If you sell physical products, inventory and cost of goods sold (COGS) are two of the most important numbers in your business. Many business owners mix them up all the time, and that affects their profit calculations.
Inventory is the products you have in stock, while cost of goods sold (COGS) is the cost of the products you’ve already sold. Inventory is an asset. COGS is an expense. When a product is sold, its cost moves from inventory to COGS.
Let’s learn this in detail, with the formula, the journal entries, and where each one appears on your financial statements.
What is inventory?
Inventory is the stock your business owns and plans to sell. As long as the items haven’t been sold, they are recorded as an asset on your balance sheet.
For retailers and online stores, inventory includes products purchased for resale. Manufacturers divide inventory into three types:
- Raw materials (materials waiting to be used in production).
- Work in process (products that are being made).
- Finished goods (products that are complete and ready to sell).
The main thing to remember is that inventory represents money invested in products. You’ve already paid for them, but they won’t generate income until they’re sold.
What is cost of goods sold (COGS)?
Cost of goods sold (COGS) is the direct cost of the products you sold during a specific period. It appears as an expense on your income statement.
COGS includes costs directly related to the products you sell, such as the purchase price, raw materials, direct labor, and shipping costs. It does not include expenses like office rent, administrative salaries, or marketing. Those are operating expenses and not COGS.
According to the IRS, businesses that make or buy goods to sell must value inventory to figure COGS, and it’s the biggest deduction a product business takes. Calculating it correctly is important for both accurate profits and accurate taxes.
Inventory vs cost of goods sold: the key difference
Before a product is sold, its cost is recorded as inventory. After it’s sold, that same cost becomes COGS.
| Inventory | Cost of goods sold | |
|---|---|---|
| What it is | Goods you own but haven’t sold | Cost of goods you’ve sold |
| Account type | Asset | Expense |
| Statement | Balance sheet | Income statement |
| When recorded | When bought or produced | When sold |
| What it affects | Value of what you own | Gross profit |
Is COGS an asset, an expense, or a liability?
This is a common question, and the answer is simple: COGS is an expense. It is not an asset or a liability.
Inventory is the asset. Once the inventory is sold, its cost moves out of the asset account and becomes a COGS expense.
Here’s how both accounts work:
| Account | Type | Statement | Normal balance |
|---|---|---|---|
| Inventory | Current asset | Balance sheet | Debit |
| Cost of goods sold | Expense | Income statement | Debit |
A few quick answers people search for:
- Is COGS a debit or credit? COGS normally has a debit balance, so you debit it to increase the account.
- Is inventory an asset? Yes, inventory is a current asset.
- Is COGS on the balance sheet? No, COGS is on the income statement. Only unsold inventory stays on the balance sheet.
How inventory turns into COGS
Let’s say you buy a product for $40. As long as it’s in your stockroom, that $40 is recorded as inventory, which is an asset. Once you sell the product, that same $40 moves out of inventory and becomes cost of goods sold (COGS), which is an expense.
If you sell the product for $70, that’s your revenue. The difference between the selling price and the cost ($30) is your gross profit.
So, the same $40 is never counted twice. It’s either an asset (unsold) or an expense (sold), never both at once.
How to calculate COGS (formula and example)
Most small businesses calculate cost of goods sold (COGS) using this formula:
COGS = Beginning Inventory + Purchases − Ending Inventory
Beginning inventory plus purchases are called your goods available for sale. Subtract what is left at the end, and you’re left with the cost of what sold.
Once you subtract the inventory you have at the end, the amount left is your COGS.
Here’s a simple example:
- Beginning inventory: $10,000
- Purchases during the year: $50,000
- Goods available for sale: $60,000
- Ending inventory: $15,000
- COGS = $60,000 – $15,000 = $45,000
That $45,000 is your expense for the year. The remaining $15,000 stays on the balance sheet as inventory. This is the same math product sellers report in Part III of their Schedule C, where COGS reduces taxable income.
The journal entry for inventory and COGS
This is where the accounting becomes real. If you’re using a perpetual inventory system (like QuickBooks), two journal entries are recorded every time you make a sale.
First, you record the sale by debiting cash or managing your accounts receivable:
- Debit Cash or Accounts Receivable $70
- Credit Sales Revenue $70
Then you record the cost of that sale:
- Debit Cost of Goods Sold $40
- Credit Inventory $40
The second entry is what moves the product’s cost from inventory to COGS. Inventory decreases, and COGS increases by the same amount.
If you’re using a periodic inventory system, you don’t record the cost for every sale. Instead, you calculate COGS at the end of the accounting period using the formula above.
Where inventory and COGS show up on your statements
- Inventory appears on the balance sheet as a current asset.
- COGS appears on the income statement below sales and is subtracted from revenue to calculate gross profit.
The SEC‘s own guide to reading financial statements shows that COGS stays on the income statement, and analysts compare it with average inventory. It shows how quickly inventory is sold. That ratio is inventory turnover, and a low turnover may mean too much cash is invested in unsold products.
FIFO, LIFO, and weighted average
When the cost of products changes over time, you need a rule for which cost leaves inventory first. There are three common methods:
The oldest inventory costs are recorded as COGS first. When prices are rising, it results in lower COGS and higher profit.
The newest inventory costs are recorded as COGS first. This raises COGS and lowers taxable profit when prices rise. It’s allowed in the U.S. but not under international accounting standards.
All inventory costs are averaged to calculate one cost per unit.
Whichever method you choose, use it consistently from year to year so your financial records stay accurate and comparable.
Why this matters (and where it goes wrong)
Keeping inventory and cost of goods sold (COGS) accurate is essential if you want to know your true profit. If these numbers are wrong, your reports, pricing, and tax calculations can all be affected.
One common mistake we see with e-commerce businesses is not tracking inventory properly. For example, a Shopify home goods seller’s books showed a healthy profit, but their cash balance kept dropping. The problem was simple that they were recording every supplier purchase as an expense right away instead of moving the cost to COGS only when the products were sold. Because their inventory wasn’t being tracked, their profit was overstated by about $18,000, and they were close to paying tax on income they hadn’t actually earned.
After setting up proper inventory tracking in QuickBooks, COGS was recorded automatically with each sale, and their profit margins became much more accurate.
This is why every product-based business needs a well-organized chart of accounts. Inventory and COGS should each have their own account from the beginning.
This is general information, not personalized tax advice. Talk to a licensed CPA or tax professional for your specific situation.
Get your inventory and COGS right
Inventory is what you own. Cost of goods sold (COGS) is what you’ve sold. Inventory is recorded as an asset on the balance sheet, while COGS is recorded as an expense on the income statement.
When you track both correctly, you’ll know clearly about your profits, make better pricing decisions, and have more accurate tax reporting.
If your bookkeeping isn’t accurate, you may not know what your business is really earning. We help product-based businesses set this up correctly every day. Book a free consultation, and we’ll make sure your inventory and cost of goods sold are tracking your true profit.
FAQs
What is the relationship between inventory and cost of goods sold?
They're directly linked by a formula: Beginning Inventory + Purchases - Ending Inventory = COGS. As products are sold, their cost moves from inventory to COGS. That's why higher ending inventory means lower COGS, while lower ending inventory means higher COGS.
Is cost of goods sold a debit or credit?
COGS normally has a debit balance. You debit COGS to increase it and credit inventory at the same time when goods are sold. Both inventory and COGS are debit-balance accounts, but inventory is an asset, and COGS is an expense.
What is the golden rule for inventory?
The basic rule is to keep an item's cost in inventory until it's sold. Once it's sold, move that cost to COGS. Don't record inventory as an expense before the sale.
What are the three types of inventory?
The three common types are raw materials, work in process, and finished goods. Retailers and online sellers mostly deal with finished goods, while manufacturers handle all of these.
Meet Muhammad Aqib: Our Expert in Financial Planning and Analysis
He is the founder of Predawn Accounting and has more than six years of experience helping small businesses maintain organized financial records, improve reporting accuracy, and better understand their financial position.
He is a qualified Chartered Accountant from ICAP Pakistan, holds a BS in Accounting and Finance, is an ACCA Candidate, an FMVA Certified professional, has also earned a Financial Planning and Analysis certification from the Corporate Finance Institute (CFI) and is a QuickBooks ProAdvisor Certified advisor with experience working across industries, including real estate, construction, e-commerce, SaaS, and marketing agencies.
Before founding Predawn Accounting in 2023, Mr. Aaqib worked with businesses across multiple industries, doing bookkeeping, financial reporting, financial modeling, fractional CFO, and other projects. He has also completed financial projects that helped businesses raise funding and improve financial operations.
