Inventory: Follow the Cost, Not the Product

A different way to think about merchandising accounting

Inventory accounting can feel like a collection of unrelated journal entries. Purchase inventory. Add freight. Record a sale. Record cost of goods sold.

But all of those entries are really telling one story about where the cost of the merchandise is located.

The Big Idea

When a retailer buys merchandise, the cost does not immediately become an expense.

As long as the company still owns the merchandise, that cost remains in Inventory.

When the merchandise is sold, its cost moves out of Inventory and becomes Cost of Goods Sold.

So instead of memorizing journal entries, follow the cost.

Meet Trailside Outfitters

Trailside Outfitters buys backpacks to resell to customers.

Units purchased:
100 backpacks
Purchase price:
$40 each
Freight paid by Trailside:
$500
Selling price:
$80 each
1

The Backpacks Arrive

Trailside buys 100 backpacks for $40 each on account.

Work it first: What is the total purchase cost? Which account should be debited? What is the journal entry?
Reveal the purchase solution
100 backpacks × $40 = $4,000

Under a perpetual inventory system, the company records:

Debit Inventory    $4,000
Credit Accounts Payable    $4,000

Why Inventory?

Because the company still owns all 100 backpacks. The $4,000 has not become an expense yet.

Cost location: $4,000 is sitting in Inventory on the Balance Sheet.
2

Now Add the Freight

Trailside pays $500 to transport the backpacks to its store.

Work it first: Is the $500 an immediate freight expense, or does it become part of Inventory? What is the new total inventory cost?
Reveal the freight solution

The freight is part of the cost of getting the merchandise to the location where it will be sold.

Debit Inventory    $500
Credit Cash        $500
$4,000 purchase cost + $500 freight = $4,500 total inventory cost
The freight cost did not disappear into an expense. It joined the merchandise in Inventory.
3

What Is the Cost Per Backpack?

Trailside now has 100 backpacks with a total recorded cost of $4,500.

Work it first: What is the inventory cost per backpack?
Reveal the cost-per-unit solution
$4,500 total inventory cost ÷ 100 backpacks = $45 per backpack

That $45 is the cost Trailside is carrying in Inventory for each backpack.

It is not the amount Trailside will charge customers.

Two Numbers. Two Completely Different Jobs.

Selling Price $80 What the customer pays
Inventory Cost $45 What the backpack cost Trailside

These two amounts answer two completely different accounting questions.

4

A Customer Buys One Backpack

Trailside sells one backpack for $80 cash. The backpack cost Trailside $45.

Work it first: A perpetual-system merchandise sale requires two entries. Can you write both of them?
Reveal the two sales entries

Part 1: Record the Sale

Debit Cash    $80
Credit Sales Revenue    $80

This records what Trailside earned from the customer.

Part 2: Record the Cost

Debit Cost of Goods Sold    $45
Credit Inventory          $45

This records what Trailside gave up to earn the revenue.

Follow the $45

Now that you have worked through the sale, notice what happened to the cost.

Purchase $40 enters Inventory
→
Freight $5 more per unit joins Inventory
→
Inventory $45 stays here while unsold
→
Sale $45 becomes COGS
The cost did not disappear. It moved from an asset to an expense when the merchandise was sold.

What Happens to the Other 99 Backpacks?

Only one backpack was sold.

Work it first: How much cost should remain in Ending Inventory? How much should appear in Cost of Goods Sold?
Reveal the ending inventory solution

Trailside still owns 99 backpacks.

99 backpacks × $45 cost = $4,455 Ending Inventory

That $4,455 remains on the Balance Sheet because the backpacks have not yet been sold.

1 backpack sold × $45 cost = $45 Cost of Goods Sold

That $45 appears as an expense on the Income Statement.

$4,455 Ending Inventory + $45 COGS = $4,500 total inventory cost

Where Does the Cost End Up?

Before opening the answer, decide which amount belongs on each financial statement.

Reveal the financial statement connection

Unsold Merchandise

Balance Sheet

The cost remains in Inventory.

$4,455

Sold Merchandise

Income Statement

The cost becomes Cost of Goods Sold.

$45

Common Merchandising Traps

Merchandise becomes an expense when we buy it. Tap to check
No.

Merchandise purchased for resale is recorded as Inventory.

Its cost becomes an expense only when the merchandise is sold.

Freight paid to bring inventory to the store is automatically a freight expense. Tap to check
No.

When the buyer is responsible for freight needed to bring purchased merchandise to its location, that cost is included in Inventory under the perpetual system.

If we sell a backpack for $80, Cost of Goods Sold is $80. Tap to check
No.

$80 is the selling price and becomes Sales Revenue.

Cost of Goods Sold is based on what the merchandise cost Trailside. In this example, that amount is $45.

Recording Sales Revenue completely records a merchandise sale. Tap to check
No.

Under a perpetual inventory system, the sale also requires the cost side of the transaction.

Inventory decreases and Cost of Goods Sold increases.

Can You Follow the Cost?

A retailer purchases 200 jackets for $30 each and pays $400 of freight to bring them to its store. During the period, the retailer sells 120 jackets for $65 each.

Before revealing the solution, determine:

1. Total inventory cost before any jackets are sold
2. Cost per jacket
3. Sales Revenue from the 120 jackets sold
4. Cost of Goods Sold
5. Ending Inventory
Reveal the completed solution

Step 1: Purchase cost

200 × $30 = $6,000

Step 2: Add freight

$6,000 + $400 = $6,400 total inventory cost

Step 3: Cost per jacket

$6,400 ÷ 200 = $32 per jacket

Step 4: Sales Revenue

120 × $65 = $7,800 Sales Revenue

Step 5: Cost of Goods Sold

120 × $32 = $3,840 COGS

Step 6: Ending Inventory

80 unsold jackets × $32 = $2,560 Ending Inventory

$3,840 COGS + $2,560 Ending Inventory = $6,400 total inventory cost

If You Remember Only Four Things...

1

Unsold merchandise stays in Inventory.

2

Costs needed to get inventory ready for sale become part of Inventory cost.

3

When merchandise is sold, its cost moves from Inventory to COGS.

4

Selling price creates Revenue. Inventory cost creates COGS.