Difficulty: Intermediate | Prerequisites: Basic accounting principles (debits, credits, journal entries), understanding of financial statements.
This chapter sits at the heart of any accounting course that covers the income statement and balance sheet together. Inventory is one of the largest current assets for most companies, and how you classify and measure it directly affects both cost of goods sold and reported profit. You need to understand how different types of businesses (merchandisers vs manufacturers) think about inventory, what costs get included in the inventory figure on the balance sheet, and how the two major tracking systems (perpetual and periodic) record inventory transactions differently. If you are comfortable with basic journal entries and the accounting equation, you are ready for this material.
Merchandisers carry one inventory account (finished goods bought for resale), while manufacturers split inventory across three accounts: raw materials, work-in-process, and finished goods. The cost of inventory includes the purchase price plus freight, insurance in transit, and preparation costs, minus any returns or discounts. Companies track inventory using either a perpetual system (updated continuously with every transaction) or a periodic system (updated only at period end via a physical count).
Inventory
Assets a company holds either for sale in the ordinary course of business or for use in producing goods for sale.
Think of it as: everything sitting in the warehouse or on the shop floor that the business intends to turn into revenue.
Merchandiser
A business that purchases finished goods from suppliers and resells them to customers without further processing.
In simple terms, this means a retailer or wholesaler: they buy it done, mark it up, and sell it on.
Manufacturer
A business that purchases raw materials and components and converts them into finished products for sale.
Think of it as: the company that actually makes the thing, from parts and labour, before it reaches a shop shelf.
Raw materials
The cost of components purchased from suppliers that will become part of the finished product.
In simple terms, this means the ingredients or parts before any assembly or processing has happened.
Work-in-process (WIP)
Products that are not yet complete. WIP includes the cost of raw materials used, direct labour traced to those units, and manufacturing overhead allocated to them.
Think of it as: half-built products still on the factory floor.
Finished goods
Goods that have been completed in the manufacturing process but have not yet been sold.
In simple terms, this means products ready to ship but still sitting in the warehouse.
Net purchases
Total purchases minus purchase returns and purchase discounts, plus freight-in and other necessary costs.
Think of it as: what you actually paid, net of anything you sent back or got discounted, plus shipping.
Purchase returns
Goods sent back to the supplier, which reduce the cost of inventory.
In simple terms, this means the supplier takes the goods back and your inventory cost drops accordingly.
Purchase discounts
Reductions in the amount owed to a supplier, typically for early payment, which reduce the cost of inventory.
Think of it as: the reward for paying your invoice ahead of schedule.
Freight-in (freight charges on incoming goods)
Transportation costs paid to get purchased inventory to the buyer's location. Freight-in is included in the cost of inventory.
In simple terms, this means shipping costs you pay on inbound goods become part of the inventory's value on the balance sheet.
Perpetual inventory system
A system that continually updates the inventory account and cost of goods sold account for every purchase, sale, and return as they occur.
Think of it as: a live running tally, so you always know exactly what is on hand.
Periodic inventory system
A system that adjusts the inventory account and records cost of goods sold only at the end of each reporting period, after a physical count.
In simple terms, this means you only find out your true inventory figure when you stop and count everything.
Cost of goods sold (COGS)
The total cost of inventory that was sold during the period. Under the periodic system: Beginning Inventory + Net Purchases - Ending Inventory.
Think of it as: what it cost the business to acquire the specific units that actually left the building as sales.
Temporary accounts (periodic system)
Accounts such as Purchases, Purchase Returns, Purchase Discounts, and Freight-in that are used during the period and closed out at period end to determine COGS.
In simple terms, this means holding accounts that collect information during the year so you can compute COGS in one go at the end.
The way a company classifies inventory depends on what it does with the goods.
Merchandiser
Buys merchandise in finished form and resells it.
Carries one inventory account only ("Inventory" or "Merchandise Inventory").
Cost of merchandise inventory = purchase price + any other costs necessary to get goods ready for sale.
Manufacturer
Produces goods to be sold, starting from raw inputs.
Carries three separate inventory accounts:
Raw Materials: components purchased from suppliers that will become part of the finished product.
Work-in-Process (WIP): products not yet complete. WIP includes three cost layers: the cost of raw materials consumed, the cost of direct labour (traced to units), and manufacturing overhead.
Finished Goods: completed products that have not been sold. Once a unit rolls off the production line, its accumulated cost (materials + labour + overhead) moves from WIP into Finished Goods.
The key distinction is the number of inventory accounts and the level of cost detail tracked. A merchandiser's inventory cost is straightforward (buy price + incidentals). A manufacturer must layer in labour and overhead as goods move through production stages.
The cost recorded for inventory is not just the sticker price on the invoice. It includes every necessary expenditure to:
Acquire the inventory, and
Bring it to its desired condition and location for sale (or for use in manufacturing).
Costs that are included in inventory:
Purchase price
Freight charges on incoming goods (freight-in)
Insurance costs during transit
Costs of unloading, unpacking, and preparing merchandise for sale
Costs that reduce inventory:
Purchase returns (goods sent back to the supplier)
Purchase discounts (reductions for early payment or volume)
The net purchases formula ties these together:
Net Purchases = Total Purchases - Purchase Returns - Purchase Discounts + Freight-in and Other Costs
This net figure is what flows into the cost of goods available for sale calculation.
A perpetual system keeps a running, real-time record of inventory. Every transaction hits the books as it happens.
The inventory account is continually adjusted for each:
Purchase (debit Inventory, credit Accounts Payable)
Sale (debit COGS, credit Inventory)
Return of inventory (reverse the original entry)
The cost of goods sold account is also continually adjusted each time goods are sold or returned by a customer.
This means management can determine goods on hand on any date and the number of items sold during any period without needing a physical count.
Worked example: Lothridge Wholesale Beverage Company (perpetual)
Lothridge begins 2021 with inventory of $120,000. During the year: additional inventory is purchased on account at a cost of $600,000; sales on account total $820,000; the cost of inventory sold is $540,000. The perpetual system shows ending inventory of $180,000.
Journal entries under the perpetual system:
Debit | Credit | |
|---|---|---|
To record the purchase of inventory: | ||
Inventory | 600,000 | |
Accounts Payable | 600,000 | |
To record sales on account: | ||
Accounts Receivable | 820,000 | |
Sales Revenue | 820,000 | |
To record the cost of sales: | ||
Cost of Goods Sold | 540,000 | |
Inventory | 540,000 |
Notice the perpetual system requires two entries at the point of sale: one to record the revenue and one to record the cost. The ending inventory balance ($120,000 + $600,000 - $540,000 = $180,000) is always visible in the ledger.
A periodic system does not touch the Inventory account during the period. Instead, it uses temporary accounts to collect purchase activity, then calculates COGS and adjusts Inventory in one batch at the end of the reporting period.
Temporary accounts used during the period:
Purchases
Purchase Returns
Purchase Discounts
Freight-in
At period end, these temporary accounts are combined with the Inventory account to determine cost of goods sold:
Cost of Goods Sold = Beginning Inventory + Net Purchases - Ending Inventory
Ending inventory is determined by a physical count, not by the accounting records. This is a defining feature of the periodic system: you must stop and count to know what you have.
Worked example: Lothridge Wholesale Beverage Company (periodic)
Same facts as above: beginning inventory $120,000, purchases on account $600,000, sales on account $820,000. Lothridge uses the periodic system. A physical count at year end shows ending inventory of $180,000.
Journal entries during the year under the periodic system:
Debit | Credit | |
|---|---|---|
To record the purchase of inventory: | ||
Purchases | 600,000 | |
Accounts Payable | 600,000 | |
To record sales on account: | ||
Accounts Receivable | 820,000 | |
Sales Revenue | 820,000 |
Note: no COGS entry is made at the time of sale. COGS is computed at period end.
COGS calculation: $120,000 + $600,000 - $180,000 = $540,000.
The adjusting entry at year end closes the temporary accounts and records COGS. The result is the same $540,000, but the timing and method of getting there differ.
Net Purchases
Net Purchases = Total Purchases - Purchase Returns - Purchase Discounts + Freight-in and Other Costs
Cost of Goods Sold (periodic system)
Cost of Goods Sold = Beginning Inventory + Net Purchases - Ending Inventory
Cost of Goods Available for Sale
Cost of Goods Available for Sale = Beginning Inventory + Net Purchases
Ending Inventory (perpetual system)
Ending Inventory = Beginning Inventory + Purchases - Cost of Goods Sold
(This is tracked automatically by the system; no separate formula is applied at period end.)
Most modern retailers (supermarkets, e-commerce platforms, big-box stores) use perpetual systems backed by barcode scanning and point-of-sale software, which update inventory counts in real time as items are scanned at checkout. Smaller businesses or those with very high-volume, low-value items (a hardware shop selling individual screws, for instance) may still use a periodic system because the cost of tracking every unit in real time outweighs the benefit.
Students often think freight-out (shipping goods to customers) is part of inventory cost. It is not. Only freight-in (costs to bring goods to the buyer) is included in inventory. Freight-out is a selling expense.
Students sometimes assume that the periodic and perpetual systems produce different COGS figures. They do not (assuming no errors or theft). The difference is timing and method of recording, not the final number.
A common mistake is forgetting that the perpetual system requires two journal entries at the point of sale: one for revenue and one for COGS. The periodic system records only the revenue entry during the period.
Students sometimes confuse "raw materials" with "work-in-process." Raw materials have not yet entered production. The moment they are requisitioned for use, their cost moves to WIP.
⚠️ Be able to classify inventory accounts for a merchandiser (one account) versus a manufacturer (three accounts). This is a favourite multiple-choice distinction.
⚠️ Know the net purchases formula cold. Expect a question that gives you total purchases, returns, discounts, and freight-in and asks you to compute net purchases.
⚠️ Perpetual vs periodic journal entries are heavily tested. You may be given a set of transactions and asked to prepare entries under both systems. Pay attention to whether COGS is recorded at time of sale (perpetual) or at period end (periodic).
⚠️ The COGS formula (Beginning Inventory + Net Purchases - Ending Inventory) is a near-certainty on any exam covering this chapter. Be prepared to solve for any one of the four variables if the other three are given.
⚠️ Understand that freight-in is capitalised to inventory, while freight-out is a period expense. This trips students up regularly.
True or False: A merchandiser uses three inventory accounts.
False. A merchandiser uses one inventory account. Three accounts (Raw Materials, WIP, Finished Goods) belong to a manufacturer.
Fill in the blank: Net Purchases = Total Purchases - ________ - ________ + Freight-in.
Purchase Returns; Purchase Discounts.
True or False: Under the perpetual system, cost of goods sold is recorded only at the end of the period.
False. Under the perpetual system, COGS is recorded each time a sale occurs. It is the periodic system that waits until period end.
Fill in the blank: Cost of Goods Sold = Beginning Inventory + Net Purchases - ________.
Ending Inventory.
True or False: Freight-out (delivery to customers) is included in the cost of inventory.
False. Only freight-in is included in inventory cost. Freight-out is a selling expense.
Q: A company purchases goods for $50,000, receives $2,000 in purchase returns, takes $1,500 in purchase discounts, and pays $3,000 in freight-in. What are net purchases?
A: Net Purchases = $50,000 - $2,000 - $1,500 + $3,000 = $49,500.
Q: Beginning inventory is $80,000, net purchases are $200,000, and ending inventory is $60,000. What is cost of goods sold?
A: COGS = $80,000 + $200,000 - $60,000 = $220,000.
Q: Under a perpetual inventory system, what journal entries are required when goods are sold on account for $10,000 and the cost of those goods is $6,000?
A: Two entries. First: Debit Accounts Receivable $10,000, Credit Sales Revenue $10,000. Second: Debit Cost of Goods Sold $6,000, Credit Inventory $6,000.
Q: How does the periodic system determine cost of goods sold differently from the perpetual system?
A: The periodic system calculates COGS at the end of the period using the formula: Beginning Inventory + Net Purchases - Ending Inventory (where ending inventory comes from a physical count). The perpetual system records COGS continuously as each sale occurs, so the figure accumulates in real time.
Q: Name the three inventory accounts used by a manufacturer and briefly describe each.
A: Raw Materials (components purchased from suppliers, not yet used in production), Work-in-Process (partially completed goods, including raw materials, labour, and overhead costs incurred so far), and Finished Goods (completed products awaiting sale).
Q: A company using the periodic system has beginning inventory of $120,000 and purchases of $600,000. A physical count shows ending inventory of $180,000. What is COGS?
A: COGS = $120,000 + $600,000 - $180,000 = $540,000.
This material connects directly to the income statement, where COGS is the largest expense line for most merchandising and manufacturing firms. Understanding inventory cost flows is essential before tackling inventory valuation methods in Chapter 9 (FIFO, LIFO, weighted average), because those methods determine which specific costs stay on the balance sheet and which flow to the income statement. The manufacturer's three-account structure also sets the stage for cost accounting and managerial accounting courses, where you will break down overhead allocation and standard costing in much greater detail.
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