Merchandise Inventory

Merchandise inventory is the stock of goods that a merchandising business, such as a retailer, distributor or wholesaler, has bought in finished form and holds for resale to customers. Examples are clothing in a department store, groceries in a supermarket and spare parts held by a distributor. The goods are not changed before they are sold, which distinguishes merchandise inventory from the raw materials, work in process and finished goods inventory of a manufacturer.

Merchandise inventory is reported as a current asset on the balance sheet because it is expected to be sold within a year. It is often one of a retailer's largest assets, and its cost becomes cost of goods sold when the goods are sold. General principles are covered in the entry on inventory; this entry focuses on how merchandising companies account for their stock.

The cost of merchandise inventory includes all costs needed to bring the goods to their present location and condition for sale:

• The purchase price from the supplier, less trade discounts, purchase returns and allowances, and early payment discounts taken.
• Freight-in and other inbound shipping and insurance costs, as well as import duties.
• Handling costs directly linked to getting the goods ready for sale.

Shipping costs to customers, known as freight-out, are selling expenses, not inventory costs. Goods belong in inventory when the business owns them, which depends on shipping terms: under FOB shipping point, the buyer owns goods once they leave the seller, while under FOB destination ownership passes on arrival. Goods held on consignment for another company are excluded, even though they are physically on the shelves.

Merchandisers calculate cost of goods sold from the movement in inventory:

Here $\text{Beginning inventory}$ is stock at the start of the period, $\text{Net purchases}$ is purchases plus freight-in less returns and discounts, and $\text{Ending inventory}$ is stock remaining at the period end. A bookstore begins the year with $40,000 of stock, buys $210,000 of books, pays $5,000 of freight-in and returns $3,000 of damaged copies. Its cost of goods available for sale is $252,000. A count at year end finds books costing $48,000, so cost of goods sold is $204,000. If sales are $340,000, gross profit is $136,000.

When identical items are bought at different prices, a business must choose a cost flow assumption. First-in, first-out (FIFO) assumes the oldest stock is sold first; weighted average spreads cost evenly; last-in, first-out (LIFO), allowed under US GAAP but not IFRS, assumes the newest stock is sold first. Inventory must also be written down if its net realizable value falls below cost, for example because items are damaged or out of fashion. Large retailers often estimate inventory using the retail method, which applies a cost-to-retail ratio to the retail value of stock on hand.

Merchandise inventory can be tracked with a perpetual system, which updates stock records with every sale and purchase, or a periodic system, which determines inventory only by counting at the end of each period. Even with a perpetual system, businesses carry out physical counts or cycle counting to detect inventory shrinkage.

Analysts watch the inventory turnover ratio and days sales in inventory to judge how quickly a merchant sells its stock. Rising inventory with flat sales can signal unsold goods and future markdowns. Errors in counting or pricing ending inventory affect profit directly: overstating ending inventory by $10,000 understates cost of goods sold and overstates gross profit by the same amount, and the error then reverses in the following year.