Definition of Inventory
Inventory for a retailer or distributor is the merchandise that was purchased and has not yet been sold to customers. A manufacturer's 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 and it is likely to be the largest component of the company's current assets. Since the unit cost of inventory items will change over time, a company must select a cost flow assumption (FIFO, LIFO, average) for removing the costs from inventory and sending them to the cost of goods sold.
Definition of Cost of Goods Sold
The cost of goods sold is the cost of the products that have been sold to customers during the period of the income statement. How the costs flow out of inventory will have an impact on the company's cost of goods sold. The cost of goods sold will likely be the largest expense reported on the income statement.
Example of Inventory Cost and Cost of Goods Sold
To show the connection between inventory and the cost of goods sold, let's assume that a retailer sells only one product. Let's also assume that the retailer begins the year with 100 units of the product and purchases an additional 1,500 units throughout the year. The combination of the beginning inventory plus the purchases is known 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.