Inventory and cost of goods sold accounting
For any business that sells physical goods, cost of goods sold is the number that turns sales into a meaningful profit figure — and inventory accounting is what makes it work. The central idea catches many new business owners out: buying stock is not an expense when you pay for it; it becomes an expense only when you sell it. This guide explains how inventory and cost of goods sold fit together and how COGS is calculated.
Inventory is an asset until sold
When a business buys stock to resell, it has not incurred an expense — it has swapped cash for another asset. The inventory sits on the balance sheet at its cost. Only when an item is sold does its cost move off the balance sheet and become an expense, called cost of goods sold (COGS), matched against the revenue from that sale. This matching is the point: it ensures the cost of a product and the income from selling it land in the same period, so the profit on the sale is shown correctly. Recording stock purchases straight to expense would break that matching and misstate profit.
Calculating COGS and gross profit
COGS for a period is commonly worked out with a simple flow:
- Opening inventory (value of stock at the start)
- plus purchases during the period
- minus closing inventory (value of stock still on hand at the end)
The result is the cost of what was actually sold — COGS. Sales minus COGS gives gross profit, the margin the business makes on its products before overheads. Because the calculation depends on knowing the value of inventory at the start and end, a reliable stock record or a periodic count is essential — a wrong closing-inventory figure feeds straight into a wrong COGS and a wrong profit.
We set up inventory and COGS tracking so your gross profit is right and your balance sheet reflects real stock on hand.
Avail our bookkeeping servicesValuation and consistency
Where units are bought at different prices over time, the business needs a consistent way to value what it sold and what remains — a valuation method applied the same way period after period, so results are comparable and not manipulable by choice of method. Carrying inventory also has knock-on effects elsewhere in the books: it is one of the factors that can require the accrual method, it interacts with how returns and refunds are recorded when goods come back into stock, and it makes the closing stock count a key step in the period-end close. The valuation rules that apply for tax can be specific, so a business holding significant inventory should confirm the treatment rather than improvising.
The COGS calculation, with numbers
Cost of goods sold is not what you spent on stock during the period. It is what you sold out of stock, and the difference between those two figures is the whole reason inventory sits on the balance sheet.
| Line | Amount |
|---|---|
| Opening inventory | $12,000 |
| Add: purchases and freight-in | $48,000 |
| Less: closing inventory (counted) | ($15,000) |
| Cost of goods sold | $45,000 |
On revenue of $75,000 that is a gross profit of $30,000 and a gross margin of 40%. Now run the shortcut version: expense the $48,000 of purchases as they were paid. Gross profit falls to $27,000, margin reads 36%, and the $15,000 of stock sitting in the stockroom appears nowhere on the balance sheet. The business looks less profitable and smaller than it is, in the same year.
What belongs in the cost, and what does not
The second recurring error is drawing the cost boundary in the wrong place. Costs of getting goods in and ready to sell are inventoriable; costs of getting them out to a customer are not.
| Cost | Treatment |
|---|---|
| Purchase price of goods | Inventory, then COGS on sale |
| Freight-in from supplier | Inventory |
| Import duty and customs clearance | Inventory |
| Outbound shipping to customer | Selling expense, not COGS |
| Warehouse rent | Generally operating expense |
Freight-in is the one most often missed. On a $48,000 purchase with $2,400 of inbound freight, expensing the freight separately moves $2,400 out of inventory valuation and distorts both margin and closing stock. It also means the per-unit cost used for pricing is understated by 5%.
Because the tax treatment of inventory methods and any small-business exceptions are set by the IRS and depend on your accounting method and receipts, confirm the method you are entitled to use before adopting one. The bookkeeping mechanics above hold regardless of which method applies.
Sources
This guide is written against the official and clearly labelled professional references below. Rates, thresholds and portal procedures change between reviews, so open the primary source before relying on a figure.
Questions people also ask
What is cost of goods sold?
Cost of goods sold (COGS) is the cost of the inventory a business actually sold during the period. It is deducted from sales to arrive at gross profit. The key idea is that buying inventory is not immediately an expense — it becomes an expense (COGS) only when the item is sold; until then it sits on the balance sheet as an asset.
Why is buying inventory not an expense right away?
Because until the goods are sold, the business still owns them — they are an asset, not a used-up cost. Recording a purchase of stock straight to expense would misstate profit: it would show a big cost with no matching sale. Inventory moves from asset to expense (COGS) at the moment of sale, matching the cost to the revenue it generates.
How is COGS calculated for a period?
A common approach is opening inventory plus purchases during the period, minus closing inventory — the difference is what was sold, which is COGS. This requires knowing the value of inventory on hand at the start and end of the period, which is why a stock count or a reliable inventory record matters. The method of valuing that inventory should be applied consistently.
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