Purchasing Inventory and Cost of Goods Sold (COGS)

One of the most important functions of a retail or manufacturing business is the purchase of inventory. Without inventory, there are no sales.

 

To understand inventory, you must also look at cost of goods sold. These two are like the ends of a teeter-totter. In theory, when goods are purchased for manufacture or resale, they go into inventory. When they are sold, they are taken out of inventory and plunked into cost of goods sold (COGS). Therefore, at the end of every period, the balance in the inventory account represents the cost of the items left in inventory. The amount in cost of goods sold represents the cost of those items that appear in the revenue line.

 

There are two main systems for managing the accounting of inventory: the perpetual inventory system and the periodic inventory system. The larger the company, the more likely it is to use the perpetual inventory system.

 

The perpetual inventory system adjusts the inventory every time an inventory transaction occurs. Doing so allows the inventory and COGS accounts to be accurate at any point in time.

 

When inventory is purchased, the entry to account for the purchase is as follows:

            DR     Inventory                               $4,750.00

            DR     Retail sales taxes recoverable       332.50

            CR     Cash (or Accounts payable)                        $5,082.50

 

Obviously, you would credit the bank account if you purchased the inventory with cash and the accounts payable account if you purchased it on credit.

 

When inventory is sold, the entry would be as follows:

            DR      COGS              $4,750.00

            CR Inventory                            $4,750.00                                   

 

This action places the sold goods onto the income statement where those costs belong.

 

A periodic inventory system is easier to account for and manage. All inventory purchases are posted to the COGS account until the end of the year, when the inventory is counted and an adjustment is made. The entry for the purchase of inventory would then be as follows:

            DR      COGS                                    $4,750.00

            DR     Retail sales taxes recoverable       332.50

            CR     Cash (or Accounts payable)                        $5,082.50

 

At the end of the period (usually the year, but sometimes the month), the actual inventory on hand is counted and the cost calculated. The adjustment to actual is then made through the COGS account, which then makes both accounts correct. For example, if actual inventory on hand at the end of the year was $52,450, and your books reflected the inventory total from last year of $41,231, the entry to correct both the inventory and the cost of goods sold account would be as follows:

           DR Inventory                 $11,219.00

           CR COGS                                            $11,219.00


 
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