What Is Cost of Inventory? Components & Calculation

Understanding the cost of inventory is important for businesses that produce or sell physical goods. Inventory, which includes raw materials, work-in-progress, and finished goods, represents a significant asset on a company’s balance sheet. Accurately determining its cost is essential as it directly impacts a company’s financial health, profitability, and supports internal management decisions.

Elements Included in Inventory Cost

The cost of inventory encompasses all expenses incurred to acquire, produce, and prepare goods for sale. For businesses that purchase goods for resale, direct costs include the actual purchase price of items. Discounts received from suppliers reduce this price, while freight-in (shipping expenses) are added. These are inventoriable costs, directly tied to bringing inventory to its current condition and location.

For manufacturers, inventory cost is more complex, involving several production components. Direct materials are raw goods that become part of the finished product, such as lumber for furniture or fabric for clothing. Direct labor includes wages paid to employees who convert raw materials into finished goods. Manufacturing overhead comprises all other indirect production costs, such as factory utilities, depreciation on factory equipment, and indirect labor.

Direct materials, direct labor, and manufacturing overhead are classified as inventoriable costs, recorded as assets until products are sold. In contrast, period costs, like selling, general, and administrative expenses, are not included in inventory cost. These costs, such as advertising or sales personnel salaries, are expensed immediately in the period they are incurred rather than attached to inventory.

Methods for Valuing Inventory Cost

Businesses employ various methods to assign a cost to their inventory, each based on assumptions about inventory flow. The three most common methods are First-In, First-Out (FIFO), Last-In, First-Out (LIFO), and Weighted-Average Cost. The chosen method significantly influences the reported value of inventory and cost of goods sold.

The First-In, First-Out (FIFO) method assumes the oldest inventory items purchased or produced are sold first. The cost of goods sold reflects the earliest acquired inventory. Remaining inventory is valued using the costs of the most recently purchased or produced items. FIFO often aligns with the physical flow of goods, especially for perishable items or those with a limited shelf life.

Conversely, the Last-In, First-Out (LIFO) method assumes the most recently purchased or produced inventory items are sold first. Under LIFO, the cost of goods sold reflects the newest inventory, while remaining inventory is valued at the cost of the oldest items. While LIFO is permitted under United States Generally Accepted Accounting Principles (GAAP), it is not allowed under International Financial Reporting Standards (IFRS).

The Weighted-Average Cost method calculates an average cost for all inventory units available for sale during a period. This average cost applies to both goods sold and remaining inventory. This method can smooth out price fluctuations by blending all purchase costs. It is often used when inventory items are indistinguishable or tracking individual unit costs is impractical.

How Inventory Cost Affects Financial Reporting

The cost of inventory directly impacts a company’s financial statements, including the income statement and the balance sheet. Inventory is classified as a current asset on the balance sheet. When sold, its cost transfers from the balance sheet to the income statement as Cost of Goods Sold (COGS).

The amount reported as Cost of Goods Sold directly influences a company’s gross profit and net income. A higher COGS results in a lower gross profit and a lower net income. Conversely, a lower COGS leads to a higher gross profit and net income. This relationship means the method chosen to value inventory has a significant effect on a company’s reported profitability.

The value of ending inventory also significantly affects the balance sheet. It represents unsold goods at the end of an accounting period. An incorrect inventory balance can lead to an inaccurately reported value of assets, misleading stakeholders about the company’s financial position. For instance, with rising costs, FIFO typically results in lower COGS and higher ending inventory compared to LIFO, leading to higher reported profits and assets. Conversely, LIFO yields higher COGS and lower ending inventory, resulting in lower reported profits and assets.