Any company that sells a product carries merchandise inventory with costs that need to be tracked. Not only will tracking inventory costs help you prevent stockouts, avoid backorders, and optimize inventory ordering costs, it can also help you quickly identify rising costs that directly impact your bottom line. If that’s not enough to convince you, the IRS might. Since inventory is considered a current asset, its value must be calculated on a regular basis and reported in financial statements at the end of the year. So, what exactly counts as merchandise inventory and how do you calculate its value?
What is Merchandise Inventory?
Merchandise inventory is defined as inventory that is ready for sale, but not yet sold. Because there are many different types of businesses in a supply chain, one company’s merchandise inventory may be another company’s raw materials. Both are considered inventory and are recorded as current assets on a balance sheet, but not all inventory is merchandise inventory.
Examples of Merchandise Inventory
A manufacturer purchases steel and brass from a supplier, and turns them into tiny gears to make watches. To the supplier, the steel and brass was merchandise inventory (a.k.a. finished goods). To the manufacturer, it is considered raw materials inventory. While the gears are being fabricated they are considered Work in Process inventory. When finished, the gears are considered finished goods, or merchandise inventory ready for sale.
A watchmaker then purchases these gears and transforms them into beautiful end-product watches. To the watchmaker, the gears are considered raw materials. The half-finished watches in the workroom are considered Work in Process (WIP) inventory. Only the finished watches available for sale on the watchmaker’s eCommerce website are counted as merchandise inventory.
A retailer loves the watchmaker’s products and wants to carry them in their brick-and-mortar stores. The retailer purchases 500 watches and displays them on their eCommerce website and in stores. To the retailer, the purchased watches are considered merchandise inventory from the moment the order is placed and while they are in stock, until the moment they are sold.
What is Not Considered Merchandise Inventory?
In every example above, inventory was purchased and inventory was sold. But only the inventory that is ready for sale is considered merchandise inventory for accounting purposes. Current assets include all three types of inventory, but when calculating only the value of your merchandise inventory, you should not include:
- Raw materials
- Work-in-process inventory
- Goods that have been sold
- Other purchased goods such as office or manufacturing equipment
What Inventory Costs Are Included?
Merchandise inventory refers to the number of units on hand AND its cost, or dollar value. For accounting purposes, merchandise inventory cost is what must be reported. The value or cost of your merchandise inventory is critical to determining Cost of Goods Sold (COGS), which directly affects profitability.
In our watchmaking example, costs were incurred by each partner in the supply chain. Raw materials were purchased and turned into finished goods, and finished goods were purchased, shipped, and stocked. Labor, materials, and overhead costs must all be included when calculating the value of merchandise inventory.
How to Calculate the Value of Merchandise Inventory
1. Calculate the cost of each unit of inventory
- For manufacturers, this number includes the cost of the raw materials used, freight and storage costs, direct labor, and all manufacturing costs including indirect labor, overhead, depreciation of machinery, utilities, etc.
- For retailers, this number includes the purchase price and the carrying/holding costs associated with storing it in a warehouse.
2. Count the number of unsold units
3. Calculate the value of merchandise inventory
The merchandise inventory you have on hand at the end of an accounting period is known as ending inventory. The ending inventory from the last period becomes beginning inventory for the next period.
Inventory Valuation Methods
Since costs are not static and tend to rise over time, accountants have a choice in how they calculate inventory costs or, for manufacturers, the Cost of Goods Manufactured (COGM). When actual costs are difficult to track, dollar values are attributed according to the cash flow method chosen by the company, whether FIFO (first in, first out), LIFO (last in, first out), Weighted Average, or Specific Identification method.
FIFO (First In, First Out)
The FIFO inventory method assumes that your inventory is being sold in the order it was purchased. The cost of the oldest item in the warehouse is attributed to the first item sold that month, regardless of its actual cost. Because the cost of purchasing goods tends to rise over time, the FIFO method can result in rising ending inventory values. As older, less costly inventory is sold, you are left with higher-value, more recently purchased goods. During periods of inflation or rising costs, this method is preferred by accountants.
LIFO (Last In, Last Out)
The LIFO inventory method assumes that the newest inventory is sold first. Under this method, the cost of the most recently purchased item is the cost attributed to the first item sold that month. Because the cost of purchasing goods tends to rise over time, ending inventory values tend to decrease when using the LIFO method. As higher-value inventory is sold, you are left with older, less expensive goods. This method is less commonly used.
Under the Weighted Average inventory method, all costs are averaged. Total purchase costs and total COGS are divided by the number of units purchased or sold. To arrive at the ending inventory value, you multiply the number of units left at the end of the month by the average cost per unit. This is the easiest method to manage, but not practical if the cost of your products varies widely.
This method assigns an exact cost to each unit of merchandise. It is the most precise method, but difficult to manage as your business grows.
The inventory accounting method chosen in your first year of business should be followed consistently year over year, and cannot be changed without applying for permission from the IRS. Switching is not a good idea unless absolutely necessary because it muddles your picture of costs and profitability over time.
Periodic vs. Perpetual Inventory
Some businesses take inventory periodically, others use real-time perpetual inventory systems integrated with their warehouse management software or order fulfillment software platform to track inventory constantly.
It used to be that businesses would have to shut down while every item of inventory was physically counted. Smaller businesses still do this periodically, hence the name periodic inventory method. Fast-moving inventory may be counted weekly, others kinds monthly, quarterly, or annually.
A tech-forward third-party logistics company (3PL) will have a robust order fulfillment software platform that tracks every item in its warehouse. This gives eCommerce companies real-time inventory tracking capabilities. Companies whose inventory management systems integrate with their 3PL warehouse software systems know exactly how much inventory they have on hand for every SKU, and can set up automatic reorder points to prevent stockouts. Their 3PL may also conduct a physical inventory count periodically, just to make sure the numbers line up.
How to Use Merchandise Inventory to Calculate COGS
When merchandise is sold, its cost is no longer included in merchandise inventory calculations. Instead it is reported for that period as Cost of Goods Sold (COGS). When you subtract COGS from sales, the remainder is the company’s gross profit.
So, Cost of Goods Sold can be calculated by starting with the value of your beginning inventory, adding the value of any inventory purchased during that period, and subtracting the value of your merchandise inventory left at the end of the period (ending inventory).
No matter how accurate your inventory accounting system is, there will always be inventory write-offs due to dead (unsellable) stock, returns, and shrinkage. Merchandise inventory must be reduced by that amount, or Cost of Goods Sold increased by that amount.
Inventory Tracking is Key to Profitability
Knowing how much inventory you have on hand at any given time, as well as how much it’s worth, gets more important and more difficult as eCommerce business grows. Best-selling items need to be carefully watched to prevent stockouts, and slower moving items need to be monitored to minimize carrying or holding costs. Furthermore, when inventory costs increase, margins shrink and profits decrease.A 3PL such as ShipMonk has the systems in place to track eCommerce inventory in real time, and can make calculating and reporting your inventory costs a simple task. Contact ShipMonk for a demo of our proprietary eCommerce fulfillment software, and see how much easier it can be to manage inventory levels when you have complete transparency into the fulfillment process.