Cost of Goods Sold.docx

Cost of Goods Sold – COGS
By ADAM HAYES
Reviewed By JULIUS MANSA
Updated Apr 27, 2020
What Is Cost of Goods Sold – COGS?
Cost of goods sold (COGS) refers to the direct costs of producing the goods sold by a
company. This amount includes the cost of the materials and labor directly used to
create the good. It excludes indirect expenses, such as distribution costs and sales
force costs.
Cost of goods sold is also referred to as "cost of sales."
KEY TAKEAWAYS
 Cost of goods sold (COGS) includes all of the costs and expenses directly
related to the production of goods.
 COGS excludes indirect costs such as overhead and sales & marketing.
 COGS is deducted from revenues (sales) in order to calculate gross profit and
gross margin. Higher COGS results in lower margins.
 The value of COGS will change depending on the accounting standards used in
the calculation.
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Examining Costs Of Goods Sold (COGS)
Formula and Calculationfor COGS
begin{aligned} &text{COGS}=text{BeginningInventory}+text{P}-
text{EndingInventory}&textbf{where}
&text{P}=text{Purchases duringtheperiod}end{aligned}
COGS=BeginningInventory+P−EndingInventorywhereP=Purchasesd
uringthe period
Inventory that is sold appears in the income statement under the COGS account. The
beginning inventory for the year is the inventory left over from the previous year—
that is, the merchandise that was not sold in the previous year. Any additional
productions or purchases made by a manufacturing or retail company are added to
the beginning inventory. At the end of the year, the products that were not sold are

subtracted from the sum of beginning inventory and additional purchases. The final
number derived from the calculation is the cost of goods sold for the year.
COGS only applies to those costs directly related to producing goods intended for
sale.
The balance sheet has an account called the current assets account. Under this
account is an item called inventory. The balance sheet only captures a company’s
financial health at the end of an accounting period. This means that the inventory
value recorded under current assets is the ending inventory. Since the beginning
inventory is the inventory that a company has in stock at the beginning of its
accounting period, it means that the beginning inventory is also the company’s
ending inventory at the end of the previous accounting period.
What Does the COGS Tell You?
The COGS is an important metric on the financial statements as it is subtracted
from a company’s revenues to determine its gross profit. The gross profit is a
profitability measure that evaluates how efficient a company is in managing its labor
and supplies in the production process.
Because COGS is a cost of doing business, it is recorded as a business expense on the
income statements. Knowing the cost of goods sold helps analysts, investors, and
managers estimate the company’s bottom line. If COGS increases, net income will
decrease. While this movement is beneficial for income tax purposes, the business
will have less profit for its shareholders. Businesses thus try to keep their COGS low
so that net profits will be higher.
Cost of goods sold (COGS) is the cost of acquiring or manufacturing the products
that a company sells during a period, so the only costs included in the measure are
those that are directly tied to the production of the products, including the cost of
labor, materials, and manufacturing overhead. For example, the COGS for an
automaker would include the material costs for the parts that go into making the car
plus the labor costs used to put the car together. The cost of sending the cars to
dealerships and the cost of the labor used to sell the car would be excluded.
Furthermore, costs incurred on the cars that were not sold during the year will not
be included when calculating COGS, whether the costs are direct or indirect. In other
words, COGS includes the direct cost of producing goods or services that were
purchased by customers during the year.

As a rule of thumb, if you want to know if an expense falls under COGS, ask: "Would this
expense have been an expense even if no sales were generated?"
Accounting Methods and COGS
The value of the cost of goods sold depends on the inventory costing method
adopted by a company. There are three methods that a company can use when
recording the level of inventory sold during a period: First In, First Out (FIFO), Last
In, First Out (LIFO), and the Average Cost Method.1
FIFO
The earliest goods to be purchased or manufactured are sold first. Since prices
tend to go up over time, a company that uses the FIFO method will sell its least
expensive products first, which translates to a lower COGS than the COGS recorded
under LIFO. Hence, the net income using the FIFO method increases over time.1
LIFO
The latest goods added to the inventory are sold first. During periods of rising
prices, goods with higher costs are sold first, leading to a higher COGS amount. Over
time, the net income tends to decrease.1
Average Cost Method
The average price of all the goods in stock, regardless of purchase date, is used to
value the goods sold. Taking the average product cost over a time period has a
smoothing effect that prevents COGS from being highly impacted by extreme costs
of one or more acquisitions or purchases1 .
Exclusions From COGS Deduction
Many service companies do not have any cost of goods sold at all. COGS is not
addressed in any detail in generally accepted accounting principles (GAAP), but
COGS is defined as only the cost of inventory items sold during a given period. Not
only do service companies have no goods to sell, but purely service companies also
do not have inventories. If COGS is not listed on the income statement, no deduction
can be applied for those costs.2
Examples of pure service companies include accounting firms, law offices, real
estate appraisers, business consultants, professional dancers, etc. Even though all of
these industries have business expenses and normally spend money to provide their
services, they do not list COGS. Instead, they have what is called "cost of services,"
which does not count towards a COGS deduction.
Cost of Revenue vs. COGS

Costs of revenue exist for ongoing contract services that can include raw materials,
direct labor, shipping costs, and commissions paid to sales employees. These items
cannot be claimed as COGS without a physically produced product to sell, however.
The IRS website even lists some examples of "personal service businesses" that do
not calculate COGS on their income statements. These include doctors, lawyers,
carpenters, and painters.3
Many service-based companies have some products to sell. For example, airlines
and hotels are primarily providers of services such as transport and lodging,
respectively, yet they also sell gifts, food, beverages, and other items. These items
are definitely considered goods, and these companies certainly have inventories of
such goods. Both of these industries can list COGS on their income statements and
claim them for tax purposes.3
Operating Expenses vs. COGS
Both operating expenses and cost of goods sold (COGS) are expenditures that
companies incur with running their business. However, the expenses are
segregated on the income statement. Unlike COGS, operating expenses (OPEX) are
expenditures that are not directly tied to the production of goods or services.
Typically, SG&A (selling, general, and administrative expenses) are included under
operating expenses as a separate line item. SG&A expenses are expenditures that
are not directly tied to a product such as overhead costs. Examples of operating
expenses include the following:
 Rent
 Utilities
 Office supplies
 Legal costs
 Sales and marketing
 Payroll
 Insurance costs
Limitations of COGS
COGS can easily be manipulated by accountants or managers looking to cook the
books. It can be altered by:
 Allocating to inventory higher manufacturing overhead costs than those
incurred
 Overstating discounts
 Overstating returns to suppliers
 Altering the amount of inventory in stock at the end of an accounting period
 Overvaluing inventory on hand

 Failing to write-off obsolete inventory
When inventory is artificially inflated, COGS will be under-reported which, in turn,
will lead to higher than the actual gross profit margin, and hence, an inflated net
income.
Investors looking through a company’s financial statements can spot unscrupulous
inventory accounting by checking for inventory buildup, such as inventory rising
faster than revenue or total assets reported.
Example of How to Use COGS
As a historical example, let's calculate the cost of goods sold for J.C. Penney (NYSE:
JCP) for fiscal year (FY) ended 2016. The first step is to find the beginning and
ending inventory on the company's balance sheet:
 Beginning inventory: Inventory recorded on the fiscal year ended 2015 =
$2.72 billion
 Ending inventory: Inventory recorded on the fiscal year ended 2016 = $2.85
billion
 Purchases during 2016: Using the information above = $8.2 billion4
Using the formula for COGS, we can compute the following:
 $2.72 + 8.2 - 2.85 = $8.07 billion
If we look at the company's 2016 income statement, we see that the reported COGS
is $8.07 billion, the exact figure that we calculated here.5
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Introduction to Inventory and Cost of Goods
Sold

Did you know?To make the topic of Inventory and Cost of Goods Sold even easier to understand, we
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to our inventory and cost of goods sold cheat sheet, flashcards, quick tests, business forms, and more.
Inventory is merchandise purchased bymerchandisers(retailers, wholesalers, distributors)for the
purpose of beingsold to customers.The cost of the merchandise purchased but not yet sold is reported
in the account Inventoryor Merchandise Inventory.
Inventoryis reported as a current asset on the company's balance sheet. Inventoryis a significant asset
that needsto be monitored closely. Too much inventory can result in cash flow problems, additional
expenses(e.g., storage, insurance), and losses if the itemsbecome obsolete. Too littleinventory can
result in lost salesand lost customers.
Because of the cost principle, inventoryis reported on the balance sheet at the amount paid
to obtain (purchase) the merchandise, not at its sellingprice.
Inventoryis also a significant asset of manufacturers. However, in order to simplify our explanation, we
will focus on a retailer.
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Cost of Goods Sold
Cost of goods sold is the cost of the merchandise that was sold to customers. The cost of goods sold is
reported on the income statement when the sales revenues of the goods sold are reported.
A retailer'scost of goods sold includesthe cost from its supplier plus any additional costs necessaryto
get the merchandise intoinventory and ready for sale. For example, let'sassume that Corner Shelf
Bookstore purchasesa college textbook from a publisher. IfCorner Shelf's cost from the publisher is $80
for the textbook plus$5 in shippingcosts, Corner Shelf reports$85 in itsInventory account until the
book is sold. When the book is sold, the $85 is removed from inventory and is reported as cost of goods
sold on the income statement.
When Costs Change
If the publisher increasesthe sellingprices of its books, the bookstore will have a higher cost for
the next book it purchasesfrom the publisher. Anybooks in the bookstore's inventorywill continue to
be reported at their cost when purchased. For example, ifthe Corner Shelf Bookstore hason itsshelf a
book that had a cost of $85, Corner Shelfwill continue to report the cost of that one book at itsactual
cost of $85 even if the same book now hasa cost of $90. The cost principle will not allow an amount
higher than cost to be included in inventory.
Let's assume the Corner ShelfBookstore had one book in inventory at the start of the year 2019 and at
different timesduring2019 purchased four identical books. During the year 2019 the cost of these
books increased due to a paper shortage. The following chart shows the costs of the five books that have
to be accounted for. It also assumes that none of the books has been sold as of December 31, 2019.

Special Feature: Review what you are learningby working the three interactive crossword puzzles
dedicated to thistopic. They are completelyfree. Inventory & Cost of Goods Sold Puzzles
Cost Flow Assumptions
If the Corner Shelf Bookstore sells only one of the five books, which cost should Corner Shelf report as
the cost of goods sold? Should it select $85, $87, $89, $89, $90, or an average of the five amounts? A
related question is which cost should Corner Shelf report as inventory on its balance sheet for the four
books that have not been sold?
Accounting rulesallow the bookstore to move the cost from inventory to the cost of goods sold by using
one of three cost flows:
1. First In, First Out (FIFO)
2. Last In, First Out (LIFO)
3. Average
Note that these are cost flow assumptions. This means that the order in which costs are removed from
inventory can be different from the order in which the goods are physicallyremoved from inventory. In
other words,Corner Shelf could sell the book that was on hand at December 31, 2018 but could remove
from inventory the $90 cost of the book purchased in December 2019 (if it elects the LIFOcost flow
assumption).
Inventory Systems
Each of the three cost flow assumptionslisted above can be used in either of two systems (or methods)
of inventory:
A. Periodic
B. Perpetual
A. Periodic inventory system. Under this system the amount appearingin the Inventory account is not
updated when purchasesof merchandise are made from suppliers. Rather, the Inventoryaccount is
commonly updated or adjusted only once—at the end of the year. During the year the Inventoryaccount
will likely show only the cost of inventory at the end of the previous year.

Under the periodicinventory system, purchasesof merchandise are recorded in one or
more Purchases accounts. At the end of the year the Purchases account(s) are closed and the Inventory
account is adjusted to equal the cost of the merchandise actuallyon hand at the end of the year. Under
the periodic system there is no Cost of Goods Sold account to be updated when a sale of merchandise
occurs.
In short, under the periodicinventory system there is no way to tell from the general ledger accounts
the amount of inventory or the cost of goods sold.
B. Perpetual inventory system. Under thissystem the Inventoryaccount is continuously updated. The
Inventoryaccount is increased with the cost of merchandise purchased from suppliersand it is reduced
by the cost of merchandise that has been sold to customers. (The Purchasesaccount(s) do not exist.)
Under the perpetual system there isa Cost of Goods Sold account that is debited at the time of each sale
for the cost of the merchandise that wassold. Under the perpetual system a sale of merchandise will
result in two journal entries: one to record the sale and the cash or accounts receivable, and one to
reduce inventory and to increase cost of goods sold.
Inventory Systems and Cost Flows Combined
The combination of the three cost flow assumptionsand the two inventory systemsresultsin six
available options when accounting for the cost of inventoryand calculatingthe cost of goods sold:
A1. Periodic FIFO
A2. Periodic LIFO
A3. Periodic Average
B1. Perpetual FIFO
B2. Perpetual LIFO
B3. Perpetual Average
A1. Periodic FIFO
"Periodic" meansthat the Inventoryaccount is not routinelyupdated duringthe accounting period.
Instead, the cost of merchandise purchased from suppliersisdebited to an account called Purchases.At
the end of the accounting year the Inventoryaccount is adjusted to equal the cost of the merchandise
that has not been sold. The cost of goods sold that will be reported on the income statement will be
computed by taking the cost of the goods purchased and subtractingthe increase in inventory (or
addingthe decrease in inventory).
"FIFO" isan acronym for First In, First Out. Under the FIFOcost flow assumption, the first (oldest) costs
are the first ones to leave inventoryand become the cost of goods sold on the income statement. The last
(or recent)costs will be reported as inventoryon the balance sheet.
Remember that the costs can flow differentlythan the goods. Ifthe Corner Shelf Bookstore usesFIFO,
the owner may sell the newest book to a customer, but is allowed to report the cost of goods sold as $85
(the first, oldest cost).

Let's illustrate periodicFIFOwith the amountsfrom the Corner Shelf Bookstore:
As before, we need to account for the total goods available for sale (5 books at a cost of $440). Under
FIFOwe assign the first cost of $85 to the one book that was sold. The remaining$355 ($440 - $85) is
assigned to inventory. The $355 of inventory costs consists of $87 + $89 + $89 + $90. The $85 cost
assigned to the book sold is permanentlygone from inventory.
If Corner Shelf Bookstore sellsthe textbook for $110, its gross profit under periodicFIFOwill be $25
($110 - $85). If the costs of textbooks continue to increase, FIFOwill always result in more profit than
other cost flows, because the first cost is always lower.
A2. Periodic LIFO
"Periodic" meansthat the Inventory account is not updated duringthe accountingperiod. Instead, the
cost of merchandise purchased from suppliersisdebited to an account called Purchases. At the end of
the accounting year the Inventoryaccount is adjusted to equal the cost of the merchandise that is
unsold. The other costs of goods will be reported on the income statement asthe cost of goods sold.
"LIFO" isan acronym for Last In, First Out. Under the LIFOcost flow assumption, the last (or recent)
costs are the first ones to leave inventory and become the cost of goods sold on the income statement.
The first (or oldest) costs will be reported as inventoryon the balance sheet.
Remember that the costs can flow differentlythan the goods. In other words, if Corner Shelf Bookstore
uses LIFO, the owner maysell the oldest (first) book to a customer, but can report the cost of goods sold
of $90 (the last cost).
It's important to note that under LIFO periodic (not LIFOperpetual)we wait until the entire year isover
before assigningthe costs. Then we flow the year's last costs first, even if those goods arrived after the
last sale of the year. For example, assume the last sale of the year at the Corner Shelf Bookstore occurred
on December 27. Also assume that the store's last purchase of the year arrived on December 31. Under
LIFOperiodic, the cost of the book purchased on December 31 is sent to the cost of goods sold first, even
though it's physically impossible for that book to be the one sold on December 27. (This reinforces our
previous statement that the flow of costs does not have to correspond with the physical flow of units.)
Let's illustrate periodicLIFObyusing the data for the Corner ShelfBookstore:

As before we need to account for the total goods available for sale: 5 books at a cost of $440. Under
periodic LIFOwe assign the last cost of $90 to the one book that was sold. (If two books were sold, $90
would be assigned to the first book and $89 to the second book.) The remaining$350 ($440 - $90) is
assigned to inventory. The $350 of inventory cost consists of $85 + $87 + $89 + $89. The $90 assigned to
the book that was sold is permanentlygone from inventory.
If the bookstore sold the textbook for $110, its gross profit under periodic LIFOwill be $20 ($110 - $90).
If the costs of textbooks continue to increase, LIFOwill alwaysresult in the least amount of profit. (The
reason is that the last costs will alwaysbe higher than the first costs. Higher costs result in lessprofits
and usuallylower income taxes.)
A3. Periodic Average
Under "periodic" the Inventory account is not updated and purchasesof merchandise are recorded in an
account called Purchases.Under thiscost flow assumption an average cost is calculated using the total
goods available for sale (cost from the beginninginventoryplusthe costs of all subsequent purchases
made duringthe entire year). In other words, the periodicaverage cost is calculated after the year is
over—after all the purchasesof the year have occurred. This average cost is then applied to the units
sold duringthe year as well as to the unitsin inventory at the end of the year.
As you can see, our facts remain the same-there are 5 books available for sale for the year 2019 and the
cost of the goods available is $440. The weighted average cost of the books is $88 ($440 of cost of
goods available ÷ 5 books available)and it is used for both the cost of goods sold and for the cost of the
books in inventory.

Since the bookstore sold only one book, the cost of goods sold is $88 (1 x $88). The four books still on
hand are reported at $352 (4 x $88) of cost in the Inventoryaccount. The total of the cost of goods sold
plusthe cost of the inventory should equal the total cost of goods available ($88 + $352 = $440).
If Corner Shelf Bookstore sellsthe textbook for $110, itsgross profit under the periodic average method
will be $22 ($110 - $88). This gross profit is between the $25 computed under periodic FIFOand the $20
computed under periodic LIFO.
B1. Perpetual FIFO
Under the perpetual system the Inventory account is constantly(or perpetually)changing. When a
retailer purchasesmerchandise, the retailer debitsitsInventoryaccount for the cost; when the retailer
sells the merchandise to itscustomers its Inventoryaccount is credited and its Cost of Goods
Sold account is debited for the cost of the goods sold. Rather than staying dormant as it does with the
periodic method, the Inventoryaccount balance is continuously updated.
Under the perpetual system, twotransactions are recorded when merchandise issold: (1) the sales
amount is debited to Accounts Receivable or Cash and is credited to Sales, and (2) the cost of the
merchandise sold is debited toCost of Goods Sold and is credited to Inventory. (Note: Under the periodic
system the second entryis not made.)
With perpetual FIFO, the first (or oldest) costs are the first moved from the Inventoryaccount and
debited to the Cost of Goods Sold account. The end result under perpetual FIFOisthe same as under
periodic FIFO. In other words, the first costs are the same whether you move the cost out of inventory
with each sale (perpetual)or whether you wait until the year is over (periodic).
B2. Perpetual LIFO
Under the perpetual system the Inventoryaccount is constantly(or perpetually)changing. When a
retailer purchasesmerchandise, the retailer debitsitsInventoryaccount for the cost of the merchandise.
When the retailer sellsthe merchandise to its customers, the retailer creditsits Inventoryaccount for
the cost of the goods that were sold and debitsits Cost of Goods Sold account for their cost. Rather than
staying dormant as it does with the periodic method, the Inventoryaccount balance is continuously
updated.

Under the perpetual system, twotransactions are recorded at the time that the merchandise is sold: (1)
the sales amount is debited to Accounts Receivable or Cash and is credited to Sales, and (2) the cost of
the merchandise sold is debited to Cost of Goods Sold and is credited to Inventory. (Note: Under the
periodic system the second entryis not made.)
With perpetual LIFO, the last costs available at the time of the sale are the first to be removed from the
Inventoryaccount and debited to the Cost of Goods Sold account. Since thisis the perpetual system we
cannot wait until the end of the year to determine the last cost—an entrymust be recorded at the time of
the sale in order to reduce the Inventoryaccount and to increase the Cost of Goods Sold account.
If costs continue to rise throughout the entire year, perpetual LIFOwill yield a lower cost of goods sold
and a higher net income than periodic LIFO. Generallythis meansthat periodic LIFOwill result in less
income taxesthan perpetual LIFO. (If you wish to minimize the amount paid in income taxesduring
periods of inflation, you should discussLIFOwith your tax adviser.)
Once again we'll use our example for the Corner Shelf Bookstore:
Let's assume that after Corner Shelf makesits second purchase in June 2019, Corner Shelf sells one
book. This meansthe last cost at the time of the sale was $89. Under perpetual LIFOthe following entry
must be made at the time of the sale: $89 will be credited to Inventoryand $89 will be debited to Cost of
Goods Sold. If that was the only book sold duringthe year, at the end of the year the Cost of Goods Sold
account will have a balance of $89 and the cost in the Inventoryaccount will be $351 ($85 + $87 + $89 +
$90).
If the bookstore sells the textbook for $110, its gross profit under perpetual LIFOwill be $21 ($110 -
$89). Note that thisis different than the gross profit of $20 under periodicLIFO.
B3. Perpetual Average
Under the perpetual system the Inventoryaccount is constantly(or perpetually)changing. When a
retailer purchasesmerchandise, the costs are debited to its Inventoryaccount; when the retailer sells
the merchandise to its customersthe Inventoryaccount is credited and the Cost of Goods Sold account is
debited for the cost of the goods sold. Rather than staying dormant as it does with the periodicmethod,
the Inventory account balance under the perpetual average ischanging whenever a purchase or sale
occurs.
Under the perpetual system, twosets of entriesare made whenever merchandise issold: (1) the sales
amount is debited to Accounts Receivable or Cash and is credited to Sales, and (2) the cost of the

merchandise sold is debited toCost of Goods Sold and is credited to Inventory. (Note: Under the periodic
system the second entryis not made.)
Under the perpetual system, "average" meansthe average cost of the itemsin inventory as of the date of
the sale. This average cost is multiplied bythe number of unitssold and is removed from the Inventory
account and debited tothe Cost of Goods Sold account. We use the average as of the time of the
sale because this is a perpetual method. (Note: Under the periodic system we wait until the year is over
before computingthe average cost.)
Let's use the same example again for the Corner ShelfBookstore:
Let's assume that after Corner Shelf makesits second purchase, Corner Shelfsells one book. This means
the average cost at the time of the sale was $87.50 ([$85 + $87 + $89 + $89] ÷ 4]). Because thisis a
perpetual average, a journal entry must be made at the time of the sale for $87.50. The $87.50 (the
average cost at the time of the sale) is credited to Inventoryand is debited to Cost of Goods Sold. After
the sale of one unit, three unitsremain in inventory and the balance in the Inventoryaccount will be
$262.50 (3 books at an average cost of $87.50).
After Corner Shelf makesits third purchase, the average cost per unit will change to $88.125 ([$262.50
+ $90]÷ 4). As you can see, the average cost moved from $87.50 to $88.125—thisis whythe perpetual
average method is sometimes referred to as the moving average method. The Inventory balance
is $352.50 (4 books with an average cost of $88.125 each).
Comparison of Cost Flow Assumptions
Below is a recap of the varying amountsfor the cost of goods sold, gross profit, and endinginventory
that were calculated above.

The example assumesthat costs were continuallyincreasing. The resultswould be different if costs
were decreasingor increasingat a slower rate. Consult with your tax advisor concerningthe election of
cost flow assumption.
Specific Identification
In addition to the six cost flow assumptionspresented in Parts 1 - 4, businesseshave another option:
expense to the cost of goods sold the specific cost of the specific item sold. For example, Gold Dealer, Inc.
has an inventory of gold and each nugget has an identification number and the cost of the nugget. When
Gold Dealer sells a nugget, it can expense to the cost of goods sold the exact cost of the specific nugget
sold. The cost of the other nuggetswill remain in inventory. (Alternatively, Gold Dealer could use one of
the other six cost flow assumptionsdescribed in Parts 1 - 4.)
LIFO Benefits Without Tracking Units
In Part 1 and Part 2 you saw that duringthe periods of increasing costs, LIFOwill result in less profits. In
the U.S. this can mean less income taxes paid by the company. Most companiesview lower taxesas a
significant benefit. However, the process of tracking costs and then assigningthose costs to the units
sold and the unitson hand could be too expensive for the amount of income tax savings. To gain the
benefit of LIFOwithout the tracking of costs, there is a method known as dollar value LIFO. This topic is
discussed in intermediate accountingtextbooks. The Internal Revenue Service also allows companies to
use dollar value LIFObyapplyingprice indexes. (You should seek the advice of an accounting and/or tax
professional to assess the cost and benefit of these techniques.)
Inventory Management
Over the past few decadessophisticated companies have made great stridesin reducingtheir levelsof
inventory. Rather than carry large inventories, they ask their suppliersto deliver goods "just in time."

Suppliersand merchandisershave learned to coordinate their purchasesand sales so that ordersand
shipmentsoccur automatically.
A company will realize significant benefitsif it can keep itsinventory levelsdown without losing salesor
production (if the companyis a manufacturer). For example, Dell Computershas greatlyreduced its
inventory in relationship to its sales.Since computer components have been droppingin costs as new
technologies emerge, it benefitsDell to keep only a very small inventory of components on hand. It
would be a financial hardship ifDell had a large quantityof partsthat became obsolete or decreased in
value.
Financial Ratios
Keepingtrack of inventoryis important. There are two common financial ratios for monitoring
inventory levels: (1) the InventoryTurnover Ratio, and (2) the Days' Sales in Inventory. (These are
discussed and illustrated in the Explanation of Financial Ratios.)
Estimating Ending Inventory
It is very time-consumingfor a company to physically count the merchandise unitsin its inventory. In
fact, it is not unusual for companies to shut down their operations near the end of their accounting year
just to perform inventory counts. The companymay assign one set of employees to count and tag the
itemsand another set to verify the counts. If a company hasoutside auditors, they will be there to
observe the process. (Even if the company's computerskeep track of inventory, accountants require that
the computer records be verified byactuallycounting the goods.)
If a company counts itsinventory only once per year it must estimate itsinventory at the end of each
month in order to prepare meaningful monthlyfinancial statements. In fact, a company mayneed to
estimate itsinventory for other reasons as well. For example, if a companysuffers a loss due to a
disaster such as a tornado or a fire, it will need to file a claim for the approximate cost of the inventory
that was lost. (An insurance adjuster will also compute this amount independentlyso that the company
is not paid too much or too little for its loss.)
Methods of Estimating Inventory
There are two methodsfor estimating endinginventory:
1. Gross Profit Method
2. Retail Method
1. Gross Profit Method. The gross profit method for estimatinginventoryuses the information
contained in the top portion of a merchandiser'smultiple-step income statement:

Let's assume that we need to estimate the cost of inventory on hand on June 30, 2019. From the 2018
income statement shown above we can see that the company's gross profit is 20% of the salesand that
the cost of goods sold is 80% of the sales. If those percentagesare reasonable for the current year, we
can use those percentagesto help usestimate the cost of the inventory on hand as of June 30, 2019.
While an algebraicequation could be constructed to determine the estimated amount of ending
inventory, we prefer to simplyuse the income statement format. We prepare a partial income statement
for the period beginningafter the date when inventorywas last physically counted, and endingwith the
date for which we need the estimated inventorycost. In this case, the income statement will go from
January1, 2019 until June 30, 2019.
Some of the numbersthat we need are easily obtained from sales records, customers, suppliers, earlier
financial statements,etc. For example, salesfor the first half of the year 2019 are taken from the
company's records. The beginninginventoryamount is the endinginventoryreported on the December
31, 2018 balance sheet. The purchasesinformation for the first half of 2019 is available from the
company's records or its suppliers.The amountsthat we have available are written in italics in the
following partial income statement:

We will fill in the rest of the statement with the answersto the following calculations. The amounts
in italics come from the statement above. The bold amount is the answer or result of the calculation.
This can also be calculated as80% x Sales of $56,000 = $44,800.
Insertingthisinformation into the income statement yieldsthe following:

As you can see, the endinginventory amount is not yet shown. We compute thisamount bysubtracting
cost of goods sold from the cost of goods available:
Below is the completed partial income statement with the estimated amount of endinginventory at
$26,200. (Note: It is alwaysa good idea to recheck the math on the income statement to be certain you
computed the amountscorrectly.)
2. Retail Method. The retail method can be used byretailerswho have their merchandise recordsin
both cost and retail sellingprices.A very simple illustration for using the retail method to estimate
inventory is shown here:

As you can see, the cost amountsare arranged into one column. The retail amountsare listed in a
separate column. The Goods Available amountsare used to compute the cost-to-retail ratio. In this case
the cost of goods available of $80,000 isdivided bythe retail amount of goods available ($100,000). This
resultsin a cost-to-retail ratio, or cost ratio, of 80%. To arrive at the estimated endinginventory at cost,
we multiplythe estimated endinginventoryat retail ($10,000) timesthe cost ratio of 80% to arrive at
$8,000.
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