Inventory and Cost of Goods Sold

Learn It

Inventory is the stock of products a business holds to sell to customers. When the business buys inventory, it is buying an asset — not recording an expense. The inventory sits on the balance sheet until it is sold.

Here is the key concept: buying inventory does not normally create Cost of Goods Sold immediately. The cost becomes Cost of Goods Sold only when the related inventory is sold. This separates the timing of the purchase from the timing of the expense.

As we saw in Purchases and Expenses, buying an asset is different from recording an expense. Inventory is an asset until it is sold. Then the cost moves from the inventory asset to Cost of Goods Sold.

Two Effects of Selling Inventory

When a business sells inventory, two things happen at the same time:

1. Revenue is recorded: the business earns money from the sale. As we covered in Sales and Revenue, revenue is recorded when the sale happens.
2. Cost of Goods Sold is recorded: the cost of the inventory sold moves from the inventory asset to COGS. The inventory balance goes down, and an expense is recognized.

The difference between revenue and COGS is called gross profit. Gross profit tells the business how much it earned from selling products before other expenses like rent, utilities, and payroll.

See It

A business purchases 10 items for $40 each. Total inventory cost is $400. Later, the business sells 3 items for $75 each.

Here is the journal entry when the inventory is purchased:

Notice: no expense is recorded. Inventory is an asset. Then, when 3 items are sold:

Two things happen: revenue is recorded ($225), and the cost of the sold inventory moves from the inventory asset to COGS ($120). The inventory balance drops from $400 to $280.

Returns, Damage, and Adjustments

When a customer returns a usable item, the sale is reversed. Revenue goes down, and the item goes back into inventory. COGS is also reversed — the cost returns from COGS to the inventory asset.

Sometimes inventory is damaged, lost, or stolen. In that case, the inventory must be removed from the books, but there is no sale to match it against. The cost is written off — usually to an inventory adjustment or a separate expense account. This is not COGS because the inventory was not sold.

Regular inventory counts help catch these problems. If the physical count does not match the book balance, the bookkeeper must investigate and adjust the inventory to match reality.

Perpetual vs. Periodic Inventory

There are two common ways to track inventory:

• • Perpetual inventory: the inventory balance and COGS are updated every time a sale is made. This is what most modern accounting software does.
• • Periodic inventory: the inventory balance is updated only at the end of a period, when a physical count is done. COGS is calculated as beginning inventory + purchases − ending inventory.

This lesson uses the perpetual method — COGS is recorded at the time of each sale. The concepts are the same either way: buying inventory is an asset, and the cost becomes COGS when the inventory is sold.

Do It

Complete the inventory worksheet below. Enter the units in and out for each event. Then calculate the ending units, ending inventory value, net COGS, net revenue, and gross profit.

Prove It

Answer each question, then read the explanation. There's no score — this is just to help the ideas stick.

Ready for more than a short exercise?

This worksheet gives you four events with the unit cost clearly stated. Real bookkeeping requires you to handle many products with different costs, track inventory across many sales, reconcile physical counts to the books, and deal with returns, damage, and adjustments. QBO Dojo practice clients let you apply these skills across realistic business activity inside QuickBooks Online.

Key Takeaways