What Does Merchandise Inventory Include?
Understand the full scope of merchandise inventory, including what goods are counted, ownership rules, and valuation methods for accurate financial reporting.
Merchandise inventory represents the goods a business purchases with the intention of reselling them to customers. These items are considered a current asset on a company’s balance sheet, signifying their expected conversion into cash within one operating cycle or fiscal year. For many retail or wholesale businesses, this inventory can be their most substantial asset. It plays a direct role in calculating the cost of goods sold, which in turn impacts a company’s profitability.
Types of Merchandise
Merchandise inventory includes finished goods ready for immediate sale to consumers or other businesses. These products require no further manufacturing or processing. Examples include clothing, electronics, or packaged food items.
In a manufacturing setting, merchandise inventory differs from raw materials or work-in-process inventory. Raw materials are basic components, while work-in-process refers to partially completed goods. Businesses dealing in merchandise acquire inventory in its finished state from suppliers.
The classification of merchandise inventory focuses on its resale purpose. This distinguishes it from other assets a business might hold, such as office supplies or equipment used internally, which are not intended for customer purchase. The value attributed to merchandise inventory encompasses the price paid to acquire the goods, along with any associated costs like shipping or transit insurance.
Ownership and Location
Merchandise inventory includes all goods a company legally owns, regardless of physical location. This ownership principle is important for accurate financial reporting, as items might be in transit or held by third parties.
Goods in transit are determined by shipping terms. Under Free On Board (FOB) shipping point, ownership transfers to the buyer when goods leave the seller’s location. The buyer is then responsible for the goods and risks during transit. With FOB destination, the seller retains ownership and responsibility until the goods arrive at the buyer’s specified location.
Consigned goods are held by one party (the consignee) for sale on behalf of another (the consignor). Though the consignee has physical possession, the consignor retains legal ownership until the goods are sold. Therefore, consigned goods are included in the consignor’s inventory, not the consignee’s.
Goods sent to customers on approval remain part of the seller’s merchandise inventory. Ownership stays with the seller until the customer accepts them or the approval period expires. Returned goods are reintegrated into inventory. Damaged or obsolete goods may need to be written down to their net realizable value, or fully removed if they have no resale value.
Costing Methods
The valuation of merchandise inventory impacts a company’s financial statements, affecting asset value on the balance sheet and cost of goods sold on the income statement. Businesses use specific costing methods to determine this value. These methods assume a flow of costs, not necessarily the physical flow of goods.
First-In, First-Out (FIFO) assumes the first goods purchased are the first sold. Under FIFO, the cost of the oldest inventory items is assigned to the cost of goods sold, while the most recently purchased items remain in ending inventory. This method results in a higher net income during periods of rising costs because older, lower costs are matched against current revenues.
Last-In, First-Out (LIFO) assumes the last goods purchased are the first sold. The cost of the most recent inventory items is assigned to the cost of goods sold, leaving older costs in ending inventory. LIFO can lead to a lower taxable income during inflationary periods by matching higher, current costs against sales. It is permitted under U.S. Generally Accepted Accounting Principles (GAAP) but prohibited under International Financial Reporting Standards (IFRS).
The Weighted-Average method calculates the average cost of all goods available for sale during a period. This average cost is applied to both goods sold and remaining ending inventory. This method smooths out price fluctuations, resulting in cost of goods sold and inventory values that fall between those determined by FIFO and LIFO. Consistent application of a chosen costing method is important for comparability across accounting periods.