Inventory and Cost of Sales

Learning objectives

• Calculate cost of sales using opening inventory, purchases, and closing inventory so that the cost of goods sold is matched against revenue for the period.
• Decide which costs belong in inventory by distinguishing between costs that are included in inventory and costs that are recognised as period expenses.
• Value closing inventory using FIFO and weighted average methods to produce reliable inventory and profit figures.
• Apply the lower of cost and net realisable value rule so that inventory is not reported above the amount expected to be recovered from sale.
• Explain how inventory valuation choices affect profit and net assets, and why errors in inventory create “double effects” across the statements.

Overview & key concepts

Inventory and cost of sales sit at the heart of profit measurement for businesses that buy or manufacture goods for resale. Inventory is reported as a current asset, while cost of sales is reported as an expense in the statement of profit or loss. The closing inventory figure is especially important because it affects:

• profit for the period (through cost of sales), and
• the statement of financial position (through the inventory asset).

A mistake in inventory almost always creates a double effect: it changes both profit and assets.

What inventory includes

A practical way to think about inventory is:

• what the business sells (finished goods held for resale),
• what the business is in the middle of making (partly completed goods), and
• what the business will use to make those goods (materials and consumables).

Cost of sales and the matching idea

Purchases are not automatically the expense for the period because some goods bought may remain unsold at the reporting date. Cost of sales is therefore derived by adjusting purchases for the change in inventory.

Cost of sales = Opening inventory + Net purchases + Directly attributable purchase costs − Closing inventory

Core theory and frameworks

1) Calculating cost of sales

Cost of sales is usually built up using a “cost of goods available” approach:

• Start with opening inventory.
• Add purchases (net of returns and trade discounts).
• Add directly attributable purchase costs (for example, carriage inwards and import duties).
• Deduct closing inventory (valued using an accepted method and then tested against net realisable value).

Cost of sales = Opening inventory + Net purchases + Directly attributable purchase costs − Closing inventory

Exam-marker lens: for each cost, ask whether it is part of acquiring and preparing the goods for sale in the business, or whether it is a cost of running the period / making sales. If it relates to acquiring/preparing the goods, it usually belongs in inventory cost. If it relates to selling, post-purchase storage in retail, or inefficiency, it is usually a period expense.

Trade discount vs settlement (cash) discount:

• Trade discountsreduce the purchase price of the goods and therefore reduce inventory cost.
• Settlement (cash) discountsarise from early payment terms. They are not part of inventory cost and are accounted for in line with the entity’s policy and presentation. Whichever presentation is used, they are not treated as a trade discount and do not change the list price used to measure inventory cost at initial recognition.

2) Costs included in inventory

A practical rule is to include costs that are directly tied to acquiring the goods and getting them ready to be sold in the business (costs you would not have incurred if you had not bought or produced those goods). Exclude costs that relate to selling, storage after acquisition (in most retail situations), or inefficiency.

Common inclusions:

• purchase price (net of trade discounts)
• import duties and non-recoverable taxes
• carriage inwards / freight-in
• handling costs directly linked to bringing goods in

Common exclusions:

• selling and distribution costs (advertising, sales commissions, carriage outwards)
• general administration not directly attributable to inventory
• abnormal waste (wasted materials or damaged units outside normal levels of loss)

Storage costs nuance: storage costs are generally treated as an expense unless the storage is necessary within the production process before the inventory moves into its next stage of production. For a retail business warehousing goods after purchase, expensing is typically appropriate.

3) Inventory valuation methods

FIFO (First In, First Out)

FIFO assumes the earliest goods purchased are sold first. The closing inventory is therefore made up of the most recent purchases.

Typical impact in rising prices:

• closing inventory tends to be higher
• cost of sales tends to be lower
• profit tends to be higher (all else equal)

Weighted average cost

Weighted average assigns an average cost per unit to goods available for sale.

Two common approaches:

• Periodic weighted average: one average for the whole period.
• Perpetual moving average: a new average after each purchase (used in continuous systems).

Periodic and moving average can produce different results when prices change and purchases occur at different times, because the issue price under a moving average depends on the timing of each purchase.

4) Recoverability check (often called the “lower of cost and NRV” rule)

After you have costed inventory using FIFO or an average cost, apply a practical check: can the business recover that recorded cost by selling the item? This is often referred to as the lower of cost and net realisable value rule.

A quick way to compute NRV is a three-step estimate:

• Start with the realistic selling price you expect to achieve (not a list price).
• Deduct any further costs needed to finish the item (if any).
• Deduct unavoidable costs needed to make the sale (for example, commission, specific delivery promised to customers, or other selling costs linked to that item).

The resulting amount is the maximum value the item should be carried at. If the cost in the records is higher, record a write-down for the difference and charge it to profit for the period (often within cost of sales).

NRV (per unit) = expected selling price − costs still needed to complete − costs needed to sell

5) Periodic vs continuous inventory systems

• Aperiodicsystem determines closing inventory by physical count at period-end and derives cost of sales from the cost of goods available approach.
• Acontinuous(perpetual) system updates inventory records for each purchase and sale, and then reconciles to a physical count.

The valuation principles (FIFO, weighted average, lower of cost and NRV) apply under either system, but the mechanics differ.

6) Impact on financial statements

Inventory errors and valuation choices affect both profit and net assets:

• If closing inventory is overstated, cost of sales is understated and profit is overstated; inventory (assets) is overstated.
• If closing inventory is understated, cost of sales is overstated and profit is understated; inventory (assets) is understated.

These effects reverse in the next period through the opening inventory figure.

Worked example

Narrative scenario

A retail business, ABC Ltd, operates in the UK and deals in electronic goods. At the start of March, the company had opening inventory of 200 units valued at £10 each.

During March, ABC Ltd had the following transactions:

• Purchased300 units at £12 each.
• Purchased200 units at £14 each.
• Returned50 unitsfrom the £14 batch due to defects.
• Received atrade discount of 5%on the £14 batch.
• Incurredcarriage inwards of £500on purchases.
• Paidimport duties of £200on the March purchases.
• Sold500 unitsat a selling price of£20 each.
• Conducted an inventory count at month-end, revealing150 units on hand.
• Identifiedabnormal wastage of 20 unitsfrom the £12 batch among the units on hand (damaged and not saleable).
• Expected selling price for the remaining inventory is£13 per unit, withselling expenses of £3 per unit.
• Paid£1,000 warehouse rentfor March.

Required

1. Calculate the cost of sales for March.
2. Determine the closing inventory value using FIFO.
3. Determine the closing inventory value using weighted average.
4. Apply the lower of cost and NRV rule to the closing inventory.
5. Explain the impact of inventory valuation on the financial statements.

Solution

Step 1: Reconcile units first (then cost them)

Unit flow (March)

Note: the physical count of 150 includes 20 abnormal waste units. Those 20 units are not saleable inventory at the reporting date, so they are expensed at cost and excluded from closing inventory. Their NRV is therefore irrelevant.

Step 2: Calculate net purchase cost (including trade discount and returns)

£14 batch before returns:

• 200 units × £14 = £2,800
• Trade discount (5%):
• 5% × £2,800 = £140
• Discounted cost of the £14 batch:
• £2,800 − £140 = £2,660

Cost per unit after trade discount:

• £2,660 / 200 units = £13.30 per unit

Returns (50 units) are recorded at the discounted cost:

• 50 units × £13.30 = £665

Net cost remaining for the £14 batch:

• Remaining units: 150 units
• Cost: 150 × £13.30 = £1,995

£12 batch:

• 300 units × £12 = £3,600

Net purchase cost (excluding carriage and duty):

• £3,600 + £1,995 = £5,595

Directly attributable purchase costs:

• Carriage inwards: £500
• Import duties: £200
• Total direct costs: £700

Warehouse rent (£1,000) is a period expense for a retail business and is not included in inventory cost.

Total cost of goods available:

• Opening inventory: 200 × £10 = £2,000
• Net purchases: £5,595
• Directly attributable purchase costs: £700
• Total = £8,295

Step 3: FIFO valuation (closing inventory and cost of sales)

Assumption: carriage inwards and import duties relate only to March purchases, so they are allocated across the 450 net purchased units.

Direct cost per purchased unit = £700 / 450 units = £1.5556 per unit (rounded)

Adjusted unit costs:

• £12 batch: £12.00 + £1.5556 = £13.5556 per unit
• £14 batch (after trade discount): £13.30 + £1.5556 = £14.8556 per unit

Under FIFO, the closing inventory consists of the most recent units. Since the only units left (saleable) are 130 units from the £14 batch, FIFO closing inventory at cost is:

• 130 units × £14.8556 = £1,931.22

The 20 abnormal waste units are from the £12 batch and are expensed at their cost.

FIFO issues for March:

• Units sold (500): 200 @ £10.00, 280 @ £13.5556, 20 @ £14.8556
• Abnormal waste (20): 20 @ £13.5556
• Closing saleable inventory (130): 130 @ £14.8556

FIFO calculations (carry decimals through workings; round final totals to nearest £):

Cost of sales at cost:

• 200 × £10.00 = £2,000.00
• 280 × £13.5556 = £3,795.56
• 20 × £14.8556 = £297.11
• Total = £6,092.67

Abnormal waste expense:

• 20 × £13.5556 = £271.11

Closing inventory at cost (before NRV test):

• 130 × £14.8556 = £1,931.22

Step 4: Weighted average valuation (periodic average)

Weighted average cost per unit = Total cost available / Total units available
£8,295 / 650 = £12.7615 per unit

Apply this average:

Closing inventory at cost (130 units):

• 130 × £12.7615 = £1,658.99

Cost of sales at cost (500 units):

• 500 × £12.7615 = £6,380.75

Abnormal waste expense (20 units):

• 20 × £12.7615 = £255.23

Reminder: in a moving average system, the issue price depends on the timing of purchases, so periodic and moving average costs may not match when prices change during the period.

Step 5: Apply the lower of cost and NRV rule to closing inventory

Expected selling price is £13 per unit and selling expenses are £3 per unit.

NRV per unit = £13 − £3 = £10

Closing inventory must be carried at the lower of cost and NRV:

Closing inventory (at NRV) = 130 units × £10 = £1,300

Write-down amounts:

• FIFO write-down: £1,931.22 − £1,300 = £631.22
• Weighted average write-down: £1,658.99 − £1,300 = £358.99

Step 6: Total charge to profit for March (consistent rounding)

Rounding policy: carry decimals through workings and round final totals to the nearest £.

FIFO total charge (cost of goods sold + abnormal waste + write-down):

• £6,092.67 + £271.11 + £631.22 = £6,995.00
• Rounded:£6,995

Weighted average total charge (cost of goods sold + abnormal waste + write-down):

• £6,380.75 + £255.23 + £358.99 = £6,994.97
• Rounded:£6,995

Journal entry focus (high-level)

(Exact account titles vary by entity, but the debit/credit logic is consistent.)

Purchases (cash or credit as applicable):

• Dr Inventory / Purchases
• Cr Cash / Payables

Purchase returns:

• Dr Payables (or Cash if already paid)
• Cr Inventory / Purchases

Carriage inwards and import duties (directly attributable purchase costs):

• Dr Inventory / Purchases
• Cr Cash / Payables

Abnormal wastage (expense at cost):

• Dr Abnormal loss expense (or within cost of sales)
• Cr Inventory

NRV write-down of closing inventory:

• Dr Inventory write-down expense (often within cost of sales)
• Cr Inventory

Impact on the financial statements

• Closing inventory is reported as a current asset at£1,300after the NRV write-down.
• The abnormal waste and the write-down both reduce profit for March.
• FIFO and weighted average change the split between cost of sales and inventory at cost, but the NRV test can reduce differences if NRV is significantly below cost.

Exam technique: reconcile units before costing, state assumptions clearly (for example, how freight and duty are allocated), then apply the cost formula and the lower of cost and NRV rule in that order.

Common pitfalls and misunderstandings

• Confusing trade discounts with settlement discounts (they affect different parts of the analysis).
• Using gross purchase prices instead of net prices after trade discounts.
• Recording returns at the wrong amount (returns follow the original cost basis).
• Including selling costs in inventory cost (selling costs are used in NRV, not in cost).
• Treating abnormal waste as part of closing inventory instead of expensing it.
• Forgetting purchase-related costs such as import duties and carriage inwards.
• Assuming periodic average and moving average always produce the same numbers.
• Not reconciling physical count to records before attempting valuation.

Summary

Inventory valuation affects both profit and net assets. Cost of sales is derived by adjusting purchases for opening and closing inventory and adding directly attributable purchase costs. FIFO and weighted average are both acceptable, but they can produce different figures when prices change.

After costing inventory, apply the lower of cost and net realisable value rule. If expected sale proceeds (after costs needed to sell and any finishing costs) are below cost, inventory is reduced to that lower amount and the reduction is charged to profit for the period.

FAQ

How does FIFO affect financial statements in periods of rising prices?

In rising prices, FIFO typically leaves higher-cost items in closing inventory and charges lower-cost items to cost of sales. This tends to increase the inventory asset and increase profit compared with an average cost approach (all else equal).

What is the purpose of the lower of cost and NRV rule?

It prevents inventory being reported at an amount that is not expected to be recovered from sale. If recovery is lower than recorded cost, the write-down recognises the loss in the current period.

Why are selling costs excluded from inventory cost?

Selling costs do not make inventory ready for sale; they are incurred to generate sales. They are therefore treated as period expenses, while still being relevant when calculating NRV.

How do periodic and continuous inventory systems differ?

A periodic system calculates closing inventory from a physical count at period-end and derives cost of sales. A continuous system updates inventory records for each purchase and sale and then reconciles to a physical count.

What are common pitfalls in weighted average?

Forgetting returns and losses in unit totals, calculating the average on gross prices instead of net of trade discounts, and assuming periodic and moving average costs will always match.

Why reconcile physical inventory counts with records?

Discrepancies can indicate theft, damage, or recording errors. Accurate inventory figures are essential because they affect both profit and the statement of financial position.

How does inventory valuation influence decision-making?

It affects reported profit, gross margin, liquidity measures, and how management interprets pricing, purchasing, and performance trends.

Summary (Recap)

This chapter explained how cost of sales is calculated and how closing inventory is measured using FIFO and weighted average. It clarified which costs are included in inventory, how abnormal waste is treated, and how the lower of cost and NRV rule can create a write-down that reduces profit. The worked example emphasised unit reconciliation, correct treatment of trade discounts and returns, explicit assumptions on cost allocation, and consistent rounding.

Glossary

Inventory
Goods held for resale, goods being made for sale, and inputs used to make those goods. Inventory is reported as a current asset and affects profit through cost of sales.

Cost of sales
The cost assigned to goods sold during the period, derived by adjusting purchases for opening and closing inventory and including directly attributable purchase costs.

FIFO (First In, First Out)
A costing method that assumes the earliest units acquired are sold first, leaving later (often more recent) purchase costs in closing inventory.

Weighted average cost
A costing method that uses an average cost per unit for goods available for sale. The average can be calculated for the whole period (periodic) or updated after each purchase (moving average).

Net realisable value (NRV)
The amount expected to be recovered from selling inventory after deducting any further costs needed to complete and sell it.

Carriage inwards
Transport and delivery costs of bringing goods into the business, commonly included in the cost of inventory.

Abnormal loss (abnormal waste)
Losses outside normal levels (for example, unusual damage or waste). These are expensed and excluded from closing inventory.

Write-down
A reduction in the carrying amount of inventory when NRV is lower than cost, recognised as an expense.

Inventory count
A physical check of inventory quantities, used to support the reliability of inventory records and the closing inventory figure.

Periodic inventory system
A system where inventory and cost of sales are determined at intervals (often period-end) using a physical count.

Continuous (perpetual) inventory system
A system where inventory records are updated for each movement of goods and then reconciled to physical counts.

Trade discount
A reduction from a supplier’s list price, usually linked to volume or customer status, which reduces the purchase cost of inventory.

Settlement (cash) discount
A reduction for early payment, distinct from trade discounts. It is not part of inventory cost and is presented in line with policy and presentation, without changing the initial measurement of inventory at the purchase price net of trade discounts.