Understanding Inventory vs Cost of Goods Sold in Retail

Are you struggling to make sense of the finances in your product-based business? Does the concept of inventory vs cost of goods sold leave you feeling like your head is spinning in circles? Then, I’m glad you’re here!

While your inventory and cost of goods sold ARE directly related, it’s important to understand the difference between them and WHY you must track each of them correctly in your bookkeeping. 

Today’s post will take a deep dive into the differences (and similarities) between the two in their definitions, how they’re reflected in your financial statements, and what you can do with them to IMPROVE the financial health of your business!

So, grab a cup of coffee, and let’s dive in…

Inventory vs Cost of Goods Sold Definitions 

Let’s begin with the basic definitions of inventory & cost of goods sold – or at least MY definitions of these words. 

Your inventory is the products you have on hand that you are hoping to resell to your customers. Inventory is an ASSET, meaning that it is something that you own. It’s essentially money that’s sitting on shelves, in boxes, and on display in your store. 

Your cost of goods sold is…well, it’s what the name says! It’s the COST (what you paid) of the goods that you have SOLD to your customers. Your cost of goods sold (or COGS for short), is an EXPENSE that can be deducted on your taxes.

If you’re still confused, stick around. It will start to make more sense once we see how they work together on your financial statements. Let’s move on…

Inventory vs Cost of Goods Sold on Your Financial Statements

As stated earlier, the inventory that you own is an ASSET, meaning that it’s something your business owns. Assets are represented on your balance sheet. (If you need a refresher on what the balance sheet, be sure to revisit this post). 

For simple numbers sake. Let’s say that you purchased one $10 item. That’s the only inventory you have. The inventory total on your balance sheet would be $10.

Now, let’s say that you resold that single item to a customer for $25. You have now sold that $10 of inventory, so you don’t own it anymore – your customer does. You will remove that $10 from your inventory, and it essentially gets transferred in your bookkeeping records and is now recorded as your cost of goods sold. 

Now, the $10 is shown as a Cost of Goods Sold expense on your income statement.  (If you need a refresher on how to read & understand the income statement, be sure to revisit this post).  That $10 is subtracted from your $25 gross sales, and it leave you with a $15 Gross Profit (i.e. Gross Sales – COGS, or the profit margin on your product sales)

As you can see, the value of any single inventory item is the same, whether it’s currently sitting in your inventory, or if you’ve sold it and you’re recording the related COGS. The only difference is whether that product has SOLD or not!

So, Why Does This Really Matter?

The primary reason that you want to make sure you track your inventory & COGS correctly is so you can get a true picture of your business’ profitability on your income statement. I have seen many business owners record their inventory purchases as an expense when they buy it.

Now, from a tax perspective, small businesses are allowed to do that. But, that doesn’t necessarily mean that you should.

When you expense your inventory as you buy it, you have no true way to determine if your business is turning a profit. For example, let’s say it’s the end of summer, and you’re starting to pay for a bunch of your upcoming holiday inventory for Q4.

You’re likely buying more inventory than you’re selling in certain seasons, so your expenses are going to be inflated, and potentially showing you operating at a big loss. Then, when the holiday season comes around, and you’re selling much more inventory than you’re buying, your income statement is going to show that you are WILDLY profitable. 

Accurately tracking your inventory & COGS will also help you be able to determine your break-even point. To do this, we’re actually going to work backwards on your income statement.

We’re going to start with your expenses. Let’s say that you have $10,000 in average monthly expenses. Remember, this does NOT include anything with inventory. This is going to be things such as rent, payroll, store supplies, advertising, utilities, etc… This is the amount of overhead that you have to pay each month to stay open.

Now, in order to “break-even”, you need to have $10,000 left in GROSS PROFIT (Sales – COGS). So, for simple numbers sake, let’s say that you have a 2x markup. That means that you need to have $20,000 in sales to break even each month. Here’s the formula:

$20,000 in sales – $10,000 COGS (this amount has already been paid by you, but it will essentially be used to replenish the inventory you just sold) = $10,000 Gross Profit. 

$10,000 gross profit – $10,000 overhead expenses = $0 net profit (i.e. you break even). 

Without proper tracking of inventory vs cost of goods sold, you will never be able to have a clear view of your profit margins, and whether that margin is enough to help ensure you have enough cash to meet your other business expenses.

If you need help putting this into practice in your own business, then I’d love to have you join Shopify Bookkeeping Made Simple. This course is all you need to finally feel CONFIDENT managing your own retail finances using Quickbooks Online. It walks you through the complete setup, how to do all the day-to-day bookkeeping work, AND how to read and understand your financial statement to help you make decisions that will help grow your business. If you have any questions, feel free to reach out to me on Instagram at @findingfreedomfinancial, and I would be happy to chat!

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