A retailer's inventory is the merchandise that it owns but has not yet sold. The cost of the inventory is reported on the balance sheet as a current asset. When merchandise is sold, the cost of the items sold is reported on the income statement as the cost of goods sold. The formula for the retailer's cost of goods sold is the cost of its net purchases minus the increase in inventory, or its cost of net purchases plus the decrease in inventory. This formula assures the matching of costs with the sales revenues.
A manufacturer must report three inventory amounts: raw materials (at cost), work-in-process (at cost), and unsold finished goods (at cost). The cost of these three inventories is reported on the balance sheet as a current asset. The cost of the finished goods that were sold in the current period is reported on the income statement as the cost of goods sold. The formula for a manufacturer's cost of goods sold is the cost of goods manufactured minus the increase in the finished goods inventory, or the cost of goods manufactured plus the decrease in finished goods inventory. Again, this formula assists in the matching of costs with the sales revenues.
Costs for inventory include all costs that were necessary to get the items into inventory and ready for sale. For a retailer, the cost of a product is the vendor's (supplier's) invoice amount plus any freight-in on goods purchased FOB shipping point. A manufacturer's cost of finished goods and work-in-process will be its cost of direct materials, direct labor, and manufacturing overhead.
When the costs of items are increasing, one must decide which costs will be reported as inventory and which costs will be reported as the cost of goods sold. Under the first-in, first-out (FIFO) cost flow assumption, the older (lower) costs will be leaving inventory first and the most recent costs will remain in inventory. The last-in, first-out (LIFO) cost flow assumption has the recent higher costs flowing out of inventory first (and will become the cost of goods sold). The older lower costs will remain in inventory (unless the quantity is drastically reduced).
The LIFO cost flow will likely be different from the physical movement of goods. In other words, a company can diligently rotate its stock by sending the oldest goods to customers but flow the most recent costs to the cost of goods sold on its income statement. (U.S. corporations have used LIFO for decades to minimize income taxes.)
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Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years. He is the sole author of all the materials on AccountingCoach.com. Read more about the author.