Inventory for a retailer or distributor is the merchandise that was purchased and has not yet been sold to customers. For a manufacturer, inventory consists of raw materials, packaging materials, work-in-process, and the finished goods that are owned and on hand. Inventory is generally valued at its cost. If a business has inventory it is often a major component of its current assets.

The cost of goods sold is the cost of the merchandise or products that have been sold to customers during the period of the income statement. For a company that sells goods, the cost of goods sold is usually the largest expense on its income statement. As a result, care must be taken when computing and matching the cost of goods sold with the sales revenues.

To illustrate how inventory and the cost of goods sold are connected, let's assume that a retailer carries only one product. It has 100 units of the product in inventory at the beginning of the year and purchases an additional 1,500 units during the year. Accountants refer to the combination of the beginning inventory plus the purchases for the period as the goods available for sale, which in this example is 1,600 units. If there are 125 units on hand at the end of the year, the ending inventory will report the cost of 125 units. The cost of goods sold for the year will be the cost of the 1,475 units that are no longer available.

If the per unit costs of the products (or inputs) change during the year, the company must follow a cost flow assumption [FIFO, LIFO, or average] in order to divide the cost of goods available for sale between the ending inventory and the cost of goods sold.