Inventory is a current asset appearing in the balance sheet under the head current asset as well as a major item of the income statement.
Inventories are goods held for sale in the ordinary course of business that can help the management of the company to control and improve the business profitability and operate efficiently.
By nature, the cost of goods sold is an expense and the main component of the income statement.
Cost of goods sold can be calculated using the following formula;
COST OF SALE:
Opening Stock XXX
Add: Purchases XXX
Less: Closing Stock (XXX)
There are several impacts of inventory on the cost of goods sold including Purchase and production cost of inventory plays an important role in recognizing gross profit for the period.
The figure for gross profit is achieved by deducting the cost of sale from net sales during the year.
An increase in closing inventory decreases the amount of cost of goods sold and subsequently increases gross profit.
Similarly, another impact is the difference in valuation. Inventories are measured using these three methods i.e. FIFO (first in first out) LIFO (last in first out) or weighted average cost method.
Based on these methods closing stock for the period is determined which gives different results.
Because when costs of inventories are not uniform either due to price fluctuation or inflation the choice of inventory method may either increase or decrease the value of the closing stock which increases or decreases the cost of goods sold during the year.
Inventory directly affects the cost of goods sold during the year in a number of ways either opening inventory of the current period belongs to last year closing inventory or closing inventory of the current period.
But the main causes of the cost of goods sold the account to increase or decrease is as follow,
The opening inventory for the current period is the stock leftover from last year means items of goods that are not sold during the previous year.
Every organization wants to sell its opening inventory as soon as possible because there is a risk of obsolescence or deterioration that’s why the first items of every cost of sale account show opening stock.
An overstated amount of opening stock increases the amount of cost of sales significantly and vice versa.
Similarly closing stock represents the items that are not yet sold at the end of the period.
When a closing stock is wrongly calculated say overstated it lowers the cost of goods sold and increases gross profit for the year.
On the other hand for an understated amount of closing stock when adjustment entry is made to remove the effect of extra stock it increases the cost of sale directly which increases the amount of cost of goods sold significantly and ultimately decreases the profitability of the company.
Another impact of inventory on the cost of sale is their physical obsolescence, deterioration, theft, shortage or decline in prices.
These items may not be able to sell at their original selling price that’s why they are carried at net realizable value ( NRV) in this case a reduction in price is charged to the cost of goods sold thus reducing the value of closing stock and increases the gross profit.