How to Calculate Merchandise Inventory

Merchandise inventory refers to the goods a business purchases with the intention of reselling them to customers. This includes finished products ready for sale, whether they are on store shelves, in a warehouse, or in transit. For many retailers and wholesalers, merchandise inventory represents one of their most substantial assets.

Accurately calculating merchandise inventory is important for understanding a business’s financial health and for financial reporting. Its valuation directly affects the Cost of Goods Sold (COGS), which is the direct cost of products sold during a period. COGS is subtracted from net sales to determine gross profit, a key indicator of a company’s profitability. Merchandise inventory is classified as a current asset on the balance sheet, reflecting its expected conversion to cash within a year through sales. This highlights its role in assessing a company’s liquidity.

Inventory Tracking Systems

Businesses employ different methods to track their merchandise inventory, primarily using either a perpetual or a periodic inventory system. These systems determine how inventory levels and COGS are calculated.

The perpetual inventory system continuously updates inventory records with every purchase and sale. Inventory quantities, costs, and COGS are immediately adjusted as transactions occur. Businesses using this system can access real-time information about their stock levels, aiding in timely decision-making and inventory management. This system often relies on technology like barcode scanners and point-of-sale (POS) systems for accurate, up-to-the-minute records.

In contrast, the periodic inventory system does not maintain continuous, detailed records. Inventory levels and COGS are determined at specific intervals, such as the end of an accounting period. This requires a physical count of all merchandise on hand to ascertain the ending inventory. COGS is then calculated by adding purchases to the beginning inventory and subtracting the ending inventory. This method is simpler and less costly to implement, often used by smaller businesses or those with a high volume of low-value items.

Determining Inventory Cost Components

The cost assigned to merchandise inventory encompasses all expenditures necessary to bring the goods to a salable condition and location. The total cost of inventory extends beyond the initial purchase price.

The core cost components include the actual purchase price paid to the supplier. Freight-in costs, the shipping expenses to transport goods from supplier to buyer, are included. Other direct costs of acquisition, such as insurance during transit or import duties, also become part of the inventory’s recorded value. These expenses are capitalized as part of the asset.

Excluded costs involve expenses incurred after goods are ready for sale or not directly related to acquisition. Examples include selling expenses, administrative expenses, and freight-out costs (shipping to customers). These are treated as operating expenses.

Adjustments to the cost of inventory also arise from purchase returns and allowances, which reduce the total cost of purchases. Purchase discounts, offered by suppliers for early payment, also decrease the net cost. For goods in transit, ownership depends on the shipping terms: “FOB shipping point” means the buyer owns the goods once they leave the seller’s dock, while “FOB destination” means the seller retains ownership until the goods reach the buyer’s location. Consigned goods remain part of the consignor’s inventory until sold.

Inventory Cost Flow Methods

Businesses apply a cost flow method to determine the value of ending inventory and COGS. These methods assume how costs move through inventory, impacting a company’s reported financial performance.

The First-In, First-Out (FIFO) method assumes that the first goods purchased are the first ones sold. Consequently, the inventory remaining at the end of a period consists of the most recently purchased items. In a period of rising costs, FIFO results in a lower COGS and a higher ending inventory value, which leads to a higher reported gross profit and net income. For example, if a business buys 100 units at $10 each, then 100 units at $12 each, and sells 150 units, FIFO would assign the first 100 units at $10 and 50 units at $12 to COGS, while the remaining 50 units at $12 would be ending inventory.

The Last-In, First-Out (LIFO) method assumes that the last goods purchased are the first ones sold. This means the ending inventory is composed of the earliest purchased items. During periods of rising costs, LIFO results in a higher COGS and a lower ending inventory value, leading to a lower reported gross profit and net income. Using the previous example, LIFO would assign the 100 units at $12 and 50 units at $10 to COGS, leaving 50 units at $10 as ending inventory. LIFO is not permitted under International Financial Reporting Standards (IFRS) but is allowed under U.S. Generally Accepted Accounting Principles (GAAP).

The Weighted-Average Cost method calculates the average cost of all goods available for sale during the period. This average cost is then applied to both the units sold (COGS) and the units remaining (ending inventory). This method tends to smooth out cost fluctuations. For instance, if 100 units were bought at $10 and 100 at $12, the average cost would be $11 per unit ($2200 / 200 units). If 150 units are sold, COGS would be $1,650 (150 x $11) and ending inventory would be $550 (50 x $11).

The specific identification method assigns the actual cost of each item to COGS when sold. This method is typically reserved for unique, high-value items.

Conducting a Physical Inventory Count

A physical inventory count is a methodical process of manually counting all merchandise on hand at a specific point in time. This count verifies the accuracy of inventory records and establishes the actual quantity of goods available for sale. It is important for periodic systems to determine ending inventory and COGS. For perpetual systems, it identifies and corrects discrepancies like theft, damage, or record-keeping errors.

Effective physical inventory counts require careful planning and execution. The process begins with preparation, including organizing teams, assigning areas, and preparing count tags or sheets. Each item is identified, counted, and its quantity noted. Proper cutoff procedures ensure all sales and purchases immediately before and after the count are recorded in the correct accounting period.

Differences between the physical count and system records must be investigated and reconciled. This adjusts inventory records to reflect true quantities, providing a reliable basis for financial reporting. The accuracy of the physical count directly influences the precision of the calculated merchandise inventory value.