In order to provide an accurate picture of a company’s finances, business accounting reports include multiple metrics that represent the value of non-liquid assets. Merchandise inventory is one such metric. Here’s what it is and how to calculate it for your business.
What is merchandise inventory?
Merchandise inventory refers to finished goods that are ready for sale to consumers. Merchandise inventory can be stored in a retail store, in one of your warehouses, or even with the manufacturer.
Its defining features are that your business has already paid for it and that it is ready for purchase by the end consumer. Finished sweaters stored in your company’s warehouse or bags of dog food displayed at your retail location are both merchandise inventory examples.
Merchandise inventory asset accounting
The term merchandise inventory can also refer to an asset account figure on your company’s balance sheet that represents the total cost to your business of all the unsold inventory your company owns.
One way to understand your merchandise inventory figure is in terms of its relationship to your cost of goods sold (COGS). COGS represents the total cost to your business of all products sold by your company during a particular reporting period. Merchandise inventory is a snapshot of the cost of these after you’ve purchased them from a supplier but before you’ve sold them to a consumer.
When an item sells, your accounting team will deduct its cost from your merchandise inventory account and add it to COGS. At the end of an accounting period, your accountant will calculate a merchandise inventory figure based on the cost of all leftover inventory and record this number as a current asset on your balance sheet, while COGS numbers are reported as a liability on your income statement.
What does merchandise inventory include?
Taken together with other items on a company’s income statement and balance sheet, the merchandise inventory figure can help provide a full picture of a company’s financial health. Because it represents assets already owned by a business, it also contains important information about a company’s ability to meet its financial obligations. Here’s what the merchandise inventory calculation takes into account:
- Inventory costs. Merchandising inventory includes all inventory ready to be sold to customers, regardless which storage facility it’s located in. Typically, this figure is the amount that a business has paid to a manufacturer or merchandise supplier to obtain the inventory.
- Packaging and shipping costs. The merchandise inventory calculation also includes costs to your business associated with inventory packaging, shipping, and insurance.
- A portion of consignment inventory. Consignment items are products owned by a third party that you’re selling for a share of the profits. To calculate the amount of money that consignment goods contribute to your merchandise inventory, calculate the total cost of the goods and then subtract how much you’d pay the consignor. What you’re left with is the share that your company will make upon sale.
Merchandise inventory methods
Businesses can use one of two methods to track merchandise inventory: the periodic method and the perpetual method. Here’s an overview of each:
Periodic inventory method
The periodic merchandising inventory method involves manually counting all inventory at set intervals, such as quarterly, monthly, or after a busy sales period. The periodic inventory system is more popular with small businesses, which tend to have fewer inventory items. These businesses are also more likely to house all of their inventory in one or two locations, making a physical inventory count easier to complete.
Perpetual inventory method
The perpetual merchandising inventory method uses software tools to monitor a company’s inventory levels in real time. Business owners can use inventory management software to keep track of inventory purchases, individual sales, and even returns. Although the perpetual inventory system requires more ongoing maintenance than the periodic method, it also allows business owners to know how much inventory they own at any given point. This in turn can help ensure they don’t run out of products and improve forecasting for future orders.
How to calculate merchandise inventory
- Choose your inventory valuation method
- Calculate beginning merchandise inventory
- Track inventory changes during the reporting period
- Calculate ending inventory
Merchandise inventory accounting involves calculating the total cost of all merchandise inventory at the end of a particular accounting period so that you can include it on your company’s balance sheet. Here’s how to calculate yours:
1. Choose your inventory valuation method
Businesses use different inventory valuation methods. Three of the most popular methods are known as first-in, first-out (or FIFO); last-in, first-out (LIFO); and weighted average cost (WAC).
- FIFO. The FIFO valuation method assumes that older inventory items are sold before more recently purchased inventory items. If you purchased your first 30 items in January and your second 30 items in February and sold 45 items over those two months, the FIFO method assumes that the 15 items left in stock were purchased during February. If your supplier costs changed between orders, you’d use the February number to determine the cost of the 15 items left in your merchandising inventory.
- LIFO. LIFO assumes that recently purchased inventory items are sold first. In this case, the business in the above example would use January costs to determine the value of the 15 items remaining in stock. The LIFO method is permitted under US generally accepted account principles (GAAP), but it’s typically not allowed outside of the US.
- WAC. The WAC method uses an item’s average cost over a given reporting period. To use the WAC method, you’d simply average merchandise costs across January and February and multiply the average figure by 15 to represent the 15 items remaining in stock.
Changing inventory valuation methods is complicated, so best practices include adopting one valuation method and sticking with it over time.
2. Calculate beginning merchandise inventory
To calculate existing inventory figures without manually counting all of your company’s inventory, you need to have access to a few specific pieces of inventory information. The first is
beginning inventory, which refers to your merchandise inventory figure at the start of the accounting period in question. You can find it on your company’s balance sheet for the last reporting period.
You can also calculate beginning inventory numbers based on your current merchandising inventory figure. If you don’t have either, you’ll need to perform a manual count of inventory items and multiply the total number of items by item cost according to your selected inventory valuation method. The result will be your ending merchandising inventory figure, and you can use the merchandising inventory equation in step four to work backward from there to your beginning inventory number.
3. Track inventory changes during the reporting period
Once you have your beginning inventory number, account for the following inventory changes during your reporting period:
- Purchased inventory. This refers to the cost to your business of all merchandise purchased during the accounting period as well as any associated packaging or shipping expenses. You can find this information in your accounting system under accounts payable.
- Cost of goods sold (COGS). This refers to the cost to your business of merchandise inventory sold during the accounting period in question. You can find COGS on your company’s income statement or in your accounting records.
4. Calculate ending inventory
The ending merchandise inventory equation is straightforward: You simply take the cost of what you started with (beginning inventory), add what you gained (purchased inventory), and subtract what you sold (COGS). The resulting figure represents your merchandise inventory at the end of the accounting period in question. Here’s the full merchandise inventory calculation:
Beginning merchandise inventory + purchased merchandise inventory – COGS = ending merchandise inventory value
Merchandise inventory FAQ
What is merchandise inventory turnover?
Merchandise inventory turnover is an inventory metric that refers to how quickly a company sells its inventory. High merchandise inventory turnover means that a business has sold a large percentage of its merchandise inventory during the given accounting period.
What is not included in merchandise inventory?
Business owners don’t factor in the cost of lost or damaged items when accounting for merchandise inventory on a company’s balance sheet.
Is merchandise inventory an asset or liability?
Businesses record merchandise inventory as an asset. Merchandise inventory accounts aren’t income statement accounts; instead, they’re current asset accounts included on a company’s balance sheet.
