Inventory and cost of goods sold
October's drills, costed FIFO and by weighted average, counted against the record, and written down to what they will sell for.
Northwind closed September with $1,000 of inventory: twenty cordless drills at $50 each. In October it delivers the dozen the deposit paid for, restocks at a higher price, sells a trade order and counts the shelf. Every one of those moves asks the same question: what did the goods that left cost? That figure is cost of revenue, and it decides the gross margin.
Oct 1
Opening stock: 20 drills at $50
Oct 6
The deposit order delivered: 12 drills out
Oct 10
Restock: 40 drills in at $55, on 30-day terms
Oct 20
Trade order: 30 drills out at $240 each
Oct 31
Count: 17 on the shelf against 18 on the record
Which drills left? A cost-flow assumption
Once drills bought at two prices sit on one shelf, nobody can say which physical drill went out. So the books assume an order. First-in, first-out assumes the oldest leave first. Weighted-average cost gives every drill on the shelf the same average cost. US GAAP allows both (and LIFO), and Northwind's policy is FIFO.
Prices rose in October, from $50 to $55 a drill. FIFO sends the cheaper, older drills out first, so it reports the lower cost of revenue and leaves the shelf at the newest prices: $935 against $920.83. When prices fall, the order reverses. Over the life of the stock the two methods expense the same total; they disagree about which month.
FIFO
- Good at
- The shelf is valued near current prices
- Every unit leaves at a cost it came in at — no rounding
- Watch for
In rising prices, a higher gross margin than the replacement cost supports
- Best for
- Goods that really do sell oldest-first, and most small resellers
Weighted average
- Good at
- Smooths price swings out of the margin
- No layers to track
- Watch for
- The average is recomputed after every purchase
- Each issue rounds, to the cent
- Best for
- Interchangeable goods bought often at varying prices — fuel, grain, bulk parts
The entries
Restock: forty drills arrive on 30-day terms, at the supplier's new price.
| Account | Debit | Credit |
|---|---|---|
| 1300Inventory | 2,200.00 | |
| 2000Accounts payable | 2,200.00 | |
| Balanced | 2,200.00 | 2,200.00 |
OCT-4
Sell thirty drills to the trade customer on account, and take their cost out of inventory, oldest first.
| Account | Debit | Credit |
|---|---|---|
| 1200Accounts receivable | 7,200.00 | |
| 4000Revenue | 7,200.00 | |
| 5000Cost of revenue | 1,610.00 | |
| 1300Inventory | 1,610.00 | |
| Balanced | 8,810.00 | 8,810.00 |
OCT-5, October 20. The sale, and its cost: eight drills from the September layer and twenty-two from October's.
The count
A perpetual record says what should be on the shelf. On October 31 the record says 18 drills, and the count finds 17. The missing one is shrinkage: lost, stolen, broken or never received. It leaves inventory at its FIFO cost, $55, as a loss of October. It isn't a sale, so it doesn't belong in the margin on the drills sold, and Northwind books it to its own line inside cost of revenue.
The count finds fewer drills than the record. The missing ones leave inventory as a loss.
| Account | Debit | Credit |
|---|---|---|
| 5100Inventory losses | 55.00 | |
| 1300Inventory | 55.00 | |
| Balanced | 55.00 | 55.00 |
OCT-9
The periodic system gets to the same place without a record: opening stock, plus purchases, less the count. $1,000 + $2,200 − $935 = $2,265. That's the $2,210 of drills sold plus the $55 lost, together, because a count can't tell a sale from a loss. That's what the perpetual record buys.
Step 1: Freeze the shelf
Stop receiving and shipping, or note exactly what moved during the count.
Step 2: Count blind
Two people, one counting, one recording, neither the person who keeps the record.
Step 3: Compare to the record
Every difference is investigated before it's booked: a receipt keyed twice is not shrinkage.
Step 4: Book what's real
Shrinkage at cost; then test what's left against what it will sell for.
Inventory is cost on hold. The method decides which cost leaves first, the count decides what's really there, and net realizable value caps what the rest may be carried at.
In this lesson: what happens when stock on the shelf is worth less than it cost has its own page below.
Pages in this lesson
1 page goes deeper, about 4 minutes in all. Read them in order, or open the one you need.
Where this lesson's rules come from
The sources behind this lesson's requirements, by kind. Background reading explains; it is never the authority for a rule. Anything marked as a convention is ours, not the rule-maker's.
- US GAAP
- ASC 330-10-35-1B (opens in a new tab)FIFO and average-cost inventory is carried at the lower of cost and net realizable valueFree after registration
- ASC 330 (opens in a new tab)InventoryFree after registration
- Background reading — not an authority
- Wikipedia, “Cost of goods sold” (opens in a new tab)Cost of goods soldFree to read
- Wikipedia, “FIFO and LIFO accounting” (opens in a new tab)FIFO and LIFO accountingFree to read
- Wikipedia, “Inventory valuation” (opens in a new tab)Inventory valuationFree to read
- Wikipedia, “Lower of cost or market” (opens in a new tab)Lower of cost or marketFree to read
The full map is in US GAAP, and where these rules come from.
The words this lesson teaches
Each links to its glossary definition, which also names the authority behind it and the components that render it.
- InventoryGoods held for sale, or being made for sale, carried as an asset at cost until sold — when the cost moves to cost of revenue
- Cost of revenueThe direct costs of producing the goods or delivering the services sold in the period — the line gross profit is measured after
- Perpetual inventoryUpdating the inventory account with every purchase and every sale, so cost of revenue is recorded sale by sale; the periodic alternative works it out at period end from a countConvention
- FIFOThe cost-flow assumption that the oldest units leave inventory first, so cost of revenue carries the earliest costs and the shelf the latest. When prices rise, FIFO reports the lower cost of revenue and the higher inventory
- Weighted-average costThe cost-flow assumption that every unit carries the average cost of what is on hand — in a perpetual record, recomputed after each purchase and applied to each issue
- ShrinkageThe units a physical count finds missing against the perpetual record — loss, theft, damage, miscounted receipts — taken out of inventory at cost as a loss of the periodConvention
- Net realizable valueEstimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal and transportation. FIFO and average-cost inventory is carried at the lower of cost and NRV, and the shortfall is a loss of the period it arises in
- Gross marginGross margin is a profitability metric, calculated as (Revenue − COGS) ÷ Revenue.Convention
- Inventory turnoverInventory turnover is a liquidity and working-capital metric, calculated as COGS ÷ Average inventory.Convention
In the founder glossary
This lesson’s ideas, explained for the founder running the company. Each has an entry in the founder glossary.
See also
- The accounting modelEvery Lopifi component sits on one data model, and if the model is wrong no amount of design saves the product. This page defines it, from the journal line up to basis and materiality.
- Procure to pay (AP)The payables stack from requisition to reconciliation: requisition → PO → receipt → bill → approval → payment → reconciliation.
- Margin & markupMargin is profit over price; markup is profit over cost. Solve either way.
- Journal entry for an inventory purchaseWhen inventory is bought on credit under a perpetual system, debit Inventory and credit Accounts payable. If an early-payment discount is taken, debit Accounts payable for the full bill, credit Cash for what is paid and credit Inventory for the discount.
- Journal entry for an inventory write-downWhen inventory's net realizable value falls below its cost, debit an inventory write-down expense (often within cost of goods sold) and credit Inventory for the difference.
- Inventory turnover calculatorInventory turnover is a liquidity and working-capital metric, calculated as COGS ÷ Average inventory.
- DIO calculatorDIO is a liquidity and working-capital metric, calculated as (Inventory ÷ COGS for the period) × Days in the period.
- Cash conversion cycle calculatorDSO + DIO − DPO: the days between paying suppliers and collecting from customers. Negative means customers pay before suppliers are paid
- JournalEntryDebit and credit as two columns. No signed-column variant.
- LedgerTableDouble-entry with debit/credit columns and a balance check.