In this Chapter 5 cheat sheet, you'll see terms and sections that overlap with Chapter 4 — as both focus on understanding inventory.
Use the toggle arrows to explore each section at your pace, enabling effective, focused study sessions.
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🔹 Understanding the “Flow” of Cost of Goods Sold
📌 Chapter 5 is all about the flow of inventory in a merchandising business. And, most importantly, determining what your Cost of Goods Sold (“COGS”) is when you sell goods. While this chapter might seem challenging initially, understanding it is crucial — and much easier than you think. Dive into the hypothetical scenario below, where we use a cell phone manufacturer as an example, to understand the core essence of this chapter.
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🔹 The “Holy Grail” Inventory Formula
Beginning Inventory + Net Purchases = Goods Available for Sale (GAFS) - Ending Inventory = Cost of Goods Sold (COGS)
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1. Understand this Formula Conceptually
Understanding this formula is crucial, not just for memorization but to grasp its underlying logic. Let's dive into an analogy:
Imagine you're organizing a party and you're responsible for the drinks.
- “Beginning Inventory” — like the initial bottles of alcohol you already have at home.
- “Plus Net Purchases” — the additional drinks you buy for the party.
- “Goods Available for Sale (GAFS)” — Combine what you already had with what you just bought, and you get the total number of bottles available for the party.
Now, post-party, only two things could have happened with the drinks:
- They were consumed (equivalent to goods being sold).
- They remain unconsumed (equivalent to ending inventory).
Beginning Inventory + Net Purchases = Goods Available for Sale (GAFS) - Ending Inventory = Cost of Goods Sold (COGS)
- The formula captures this simple reality. What's not consumed (Ending Inventory) when subtracted from what was available (GAFS) gives you what was consumed (COGS).
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2. Visualize the Formula Using an Example
From the example:
- You began with an inventory worth $47,000.
- Purchased additional inventory worth $62,200.
- Giving a total of $109,200 available for sale.
- At the period's end, assume that inventory worth $17,000 remains.
- Therefore, inventory worth $92,200* was sold. 109,200 - 17,000 = $92,200
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3. Another Perspective: Units of Inventory
Exam questions can show inventory in terms of total $ value or in terms of # of units. Luckily, the same formula works for both! Beginning Inventory + Net Purchases = Goods Available for Sale - Ending Inventory = COGS
For instance, explore this hypothetical scenario:
- Beginning Inventory: 500 units.
- Net Purchases: Another 700 units.
- Equals GAFS of 1200 units.
If 300 units are left remaining by the period's end, this means 900* units were sold. 1200 - 300 = 900
Key Takeaway: All inventory available for sale has two potential outcomes — it’s either sold (Cost of Goods Sold) or it remains unsold (Ending Inventory). Knowing your beginning inventory and what you've added to it (net purchases) provides clarity on what was available for sale in the first place. The subtraction of Ending Inventory simply indicates the outcome: sold or unsold. This concept, understood deeply, becomes a foundational tool for handling inventory questions in exams.
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🔹 FIFO (”first in, first out”)
📌 FIFO, standing for "First In, First Out," is an inventory accounting method. The oldest inventory costs, or the "first in," are the first to be assigned as Cost of Goods Sold (COGS). The costs of the more recent, unsold inventory remain in ending inventory.
Struggling with FIFO? My visual aid below should hopefully make the concept clearer!
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🔹 LIFO (”last in, first out”)
📌 LIFO stands for "Last In, First Out." In this inventory accounting approach, the most recent inventory costs (the "last in") are used first for Cost of Goods Sold (COGS). Meanwhile, the costs of the earliest purchased items remain untouched in the ending inventory.
Struggling with LIFO? My visual aid below should hopefully make the concept clearer!
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🔹 Weighted Average
📌 Weighted Average is an inventory accounting method that takes the combined cost of all items and averages them out. This average cost is used for both Cost of Goods Sold (COGS) and any remaining units in the ending inventory. Unlike LIFO, which prioritizes the latest costs, or FIFO, which focuses on the earliest, Weighted Average considers the overall average.
Struggling with Weighted Average? My visual aid below should hopefully make the concept clearer!
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🔹 Specific Identification
📌 Specific Identification is a unique inventory accounting method. With this approach, we “specifically identify” the cost of each item sold to determine Cost of Goods Sold (COGS). Each item's individual cost is tracked and directly linked to its sale, rather than averaging or prioritizing based on acquisition time as in LIFO or FIFO.
Struggling with Specific Identification? My visual aid below should hopefully make the concept clearer!
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🔹 What is the “Merchandise Inventory” Account?
📌 Merchandise Inventory refers to the account that records the value of inventory a business has available for sale to customers.
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📌 The cornerstone of merchandising from a buyer’s standpoint is gauging inventory costs.
- Obviously, inventory costs represent the amount paid by merchandisers to procure products intended for resale.
- However, “inventory costs” can go much deeper. While the initial purchase price of the inventory forms the core of these costs, many other transactions and considerations can influence the final recorded cost of inventory.
- Transportation-In Costs: Often, the cost to transport inventory from suppliers to the buyer's place is borne by the buyer. This transportation cost is added to the inventory cost. It's common to see terms such as 'FOB shipping point', indicating that the buyer bears freight charges.
- Import Duties and Taxes: If inventory is purchased from international suppliers, there might be import duties, tariffs, or taxes to pay. These increase the cost of inventory.
- Packaging: Custom packaging or any specific requirements to maintain the quality of goods can also add to the cost.
- Insurance: If a company insures its inventory, the insurance premium related to the period before the inventory is sold can be added to inventory costs.
- Purchase Discounts: As mentioned with credit terms (like 2/10, n/60), buyers might get a discount for paying suppliers early. This discount reduces the inventory cost.
- Purchase Returns: If goods are found defective or not according to specifications, they might be returned to the supplier, decreasing the total inventory cost.
- Purchase Allowances: Similar to returns, if the buyer decides to keep a defective product but requires compensation for the defect, the compensation (or allowance) granted by the seller would reduce the inventory cost.
- Volume Rebates: Sometimes, suppliers provide rebates when large volumes are purchased, effectively reducing the per-unit cost of inventory.
- In a perpetual system, every transaction involving inventory – be it a purchase, return, or sale – triggers a corresponding journal entry in real-time. This means your accounting system always mirrors the current inventory status.
- In contrast, the periodic system accumulates all inventory-related transactions and adjusts the inventory count only at specific intervals, typically the end of a financial period.
- All acquisitions during the period boost the beginning inventory, while adjustments for returns, discounts, and allowances get made at the end.
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🔹 Perpetual vs. Periodic Systems
IMPORTANT: The choice between a perpetual and periodic system can influence how COGS and Ending Inventory costs are determined. We’ll discuss this further in the “Items to Memorize” section of Chapter 5’s Cheat Sheet.
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Perpetual Inventory Systems
📌 In a perpetual inventory system, the Merchandiser maintains a continuous, real-time record of inventory on hand. Thanks to modern software and technologies, inventory balances are updated instantly with every purchase and sale.
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Key Features
- Continuous Tracking: Every time inventory is bought, sold, returned, or otherwise adjusted, the inventory account is updated immediately.
- Real-Time “Cost of Goods Sold” (COGS): The cost of goods sold is recognized immediately upon each sale.
- Technological Assistance: Often paired with Point-of-Sale (POS) systems, barcoding, and RFID technology to ensure real-time accuracy.
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Advantages
- Instant Financial Information: Provides up-to-date information on inventory levels and cost data.
- Loss Prevention: Helps in quickly spotting discrepancies, thus reducing theft and mismanagement.
- Enhanced Customer Experience: Retailers can inform customers about stock levels in real-time.
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Disadvantages
- Complexity: Requires sophisticated systems and software, which might be expensive.
- Administrative Work: Despite automation, system glitches, or mistakes can require manual checks.
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Periodic Inventory Systems
📌 In a periodic inventory system, the Merchandiser does not maintain a continuous, real-time record of inventory on hand. Instead, inventory balances are updated periodically, usually at the end of an accounting period (like month-end, quarter-end, or year-end).
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Key Features
- No Continuous Tracking: Inventory changes are not recorded immediately. When sales are made, only the sale amount is recorded, not the cost of goods sold.
- Physical Counts: Requires physical counts to determine ending inventory.
- Calculating “Cost of Goods Sold” (COGS): At the end of the period, COGS is calculated as:
- Beginning Inventory
- Plus Net Purchases = Goods Available for Sale
- Less Ending Inventory (determined via a physical count) = Cost of Goods Sold
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Advantages
- Simplicity: Ideal for small businesses with limited inventory items.
- Less Administrative Work: No need for real-time tracking, which reduces record-keeping.
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Disadvantages
- Delayed Financial Information: Cannot provide real-time data about the cost of goods sold or the profit margin for items.
- Risk of Theft and Loss: Without continuous tracking, theft, or other losses might not be identified quickly.
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🔹 “FOB” Terms (i.e. Free On Board)
- Free on board (FOB): This is a trade term used to indicate whether the buyer or the seller is liable for goods that are lost, damaged, or destroyed during shipment.
- FOB Shipping Point: The buyer takes ownership (and risk) once the goods leave the seller's premises and generally pays for shipping.
- FOB Destination: The seller retains ownership (and risk) until the goods reach the buyer's location. The seller typically handles the shipping costs.
