What Is Purchase Costing in Accounting?

Purchase costing is the accounting method used to find the total cost of acquiring inventory. This process is governed by the cost principle, which requires that assets like inventory are recorded at their original cost. An accurate calculation is necessary for valuing inventory on hand and determining the cost of goods sold (COGS) when items are sold.

Identifying Cost Components

To accurately calculate the total purchase cost, a business must identify all relevant expenditures. These costs are broadly categorized into those that are included in the inventory’s value and those that are treated as reductions or separate expenses. This distinction is based on whether a cost is necessary to bring the inventory to its present location and condition.

Includable Costs

The primary component of purchase cost is the invoice price from the supplier. Beyond this, several other direct costs are added to determine the full value of the inventory. Freight-in, the shipping cost to transport goods from the supplier to the business, is a common addition, as is transit insurance purchased to protect the goods during shipment.

For businesses importing goods, import duties and tariffs levied by customs authorities are part of the purchase cost. Any non-recoverable taxes, such as certain sales taxes that the business cannot reclaim, are added to the inventory’s value. Other direct costs can include fees for inspection or specific handling charges required to get the inventory ready for sale.

Reductions and Exclusions

Certain items reduce the total purchase cost or are excluded entirely. Trade discounts, which are reductions from the list price granted by a supplier, are deducted before the purchase is recorded; the net amount is used as the starting point. Other costs are treated as period expenses rather than being attached to the inventory.

An exclusion is freight-out, the cost of shipping goods to a customer, which is considered a selling expense. General and administrative overhead, such as office rent or salaries of non-production staff, are also excluded. These costs are expensed in the period they are incurred because they are not directly tied to bringing inventory to a saleable condition.

The Purchase Cost Formula

The calculation of total purchase cost follows a formula that aggregates all relevant costs and subtracts any applicable reductions. The standard formula is: Invoice Price + Additional Direct Costs – Purchase Discounts & Allowances = Total Purchase Cost.

The invoice price serves as the baseline for the calculation, to which direct costs like freight-in and import duties are added. From this subtotal, any purchase discounts or allowances are subtracted. Purchase discounts are offered by suppliers to encourage prompt payment, with terms like “2/10, n/30,” meaning a 2% discount is available if paid within 10 days.

Purchase returns and allowances also reduce the total cost. A purchase return occurs when a business sends goods back to the supplier, while an allowance is a price reduction for minor defects when the buyer keeps the goods. For example, if a business buys $5,000 of goods, incurs $300 in freight costs, and receives a $100 allowance for damaged items, the total purchase cost would be $5,200 ($5,000 + $300 – $100).

Recording Purchase Costs in Accounting Systems

The method for recording purchase costs depends on the type of inventory system a company uses: perpetual or periodic. Each system has distinct journal entries for tracking inventory and the associated costs.

Under a perpetual inventory system, inventory purchases are recorded directly into the Merchandise Inventory account, an asset on the balance sheet. For example, a $5,000 purchase on credit is recorded with a debit to Merchandise Inventory and a credit to Accounts Payable. If the company pays a $300 freight bill, the entry is another debit to Merchandise Inventory and a credit to Cash, increasing the inventory’s carrying value.

In a periodic inventory system, a temporary account called “Purchases” is used to record all inventory acquisitions. Using the same example, the initial $5,000 purchase would be a debit to Purchases and a credit to Accounts Payable. The $300 freight cost would be debited to a separate “Freight-In” account. The Merchandise Inventory account is not updated until the end of the period when a physical count determines the ending inventory and COGS.

When payment is made, any purchase discounts taken are recorded. In a perpetual system, a payment for the $5,000 invoice with a 2% discount would involve a debit to Accounts Payable for $5,000, a credit to Cash for $4,900, and a credit to Merchandise Inventory for $100. In a periodic system, the $100 credit would go to a “Purchase Discounts” contra-expense account.

Impact on Financial Statements

The final calculated purchase cost directly impacts a company’s financial statements. The accuracy of this figure influences the reported value of assets on the balance sheet and the calculation of profitability on the income statement.

On the balance sheet, the purchase cost of unsold items is the basis for the inventory’s value. This inventory must be reported at the lower of its original cost or its current market value. This rule ensures that the inventory asset is not overstated, which could mislead investors about the company’s financial position.

On the income statement, the purchase cost of sold inventory is recognized as the Cost of Goods Sold (COGS). This expense is subtracted from revenue to calculate a company’s gross profit. A higher COGS results in a lower gross profit and net income, directly affecting reported profitability and income tax liability.