As a business owner you sometimes buy products with the intention of reselling it. When you buy a product for resale it is called inventory.

Inventory becomes cost of goods sold

Inventory is classified as an asset in the balance sheet until it is sold. When sold it becomes cost of goods sold. This is consistent with the matching principle. The matching principle aims to match expenses with revenue.

Here is how it works:

• When you buy products for resale it is an asset. In your financial software, you will record inventory as an asset when a purchase is made.
• When you sell a product, the revenue has to be matched with the expense by converting your inventory asset to cost of goods sold. This is done in your financial software when you record a sale using an inventory item type.

What gets included in the cost of goods sold account?

All costs incurred to acquire merchandise and ready it for sale are included in the inventory account. Examples of costs incurred in getting inventory ready for sale:

1. Shipping and handling costs
2. Transit insurance
3. Storage costs

Any costs incurred in getting inventory for sale is added to the total cost of maintaining inventory. Inventory costs are referred to as product cost. Just like the name implies, product costs is the cost of inventory plus the costs of getting it ready for sale.

Costs added to inventory: Shipping and handling costs:

Only the costs that the business is responsible for is added to inventory. In some instances the vendor pays for the cost of transporting inventory to the buyer, when this happens then the business who is reselling the item does not add the cost of transportation to the inventory.

However, when the business pays to receive the goods, the cost of shipping is added to the inventory. The business is responsible for the costs of delivering the goods from the shipping point. As a result, the terms given to postal carrier to deliver the goods is FOB shipping point. The cost is part of the inventory asset account.

What happens when the seller transports goods to the customers?

When a business transports goods to its customers, the goods are already on the shelf so any cost incurred after that cannot be added to costs of goods sold. Costs that a business incurs in sending goods to its customers is called transportation-out costs. When the business sends goods out to the customer, the terms given to the postal carrier is FOB destination which means the seller is responsible for the goods till it reaches its destination.

Selling and administrative costs

Selling and administrative costs are costs that are not included in the cost of inventory. These include advertising, salaries of the administrative staff, sales expenses, insurance after the product is on the shelf. Selling and administrative costs are period costs because unlike product costs, they are matched to the period they incur.

 

Cost of goods sold and the income statement

The multi-step income statement shows cost of goods sold above all other expenses. As a product based business, you keep track of your cost of goods sold separately as this is important information. Your gross margin is the direct profits you make from your product before general business expenses are deducted. Here is the layout of the multi-step income statement: