Merchandise inventory is the cost of goods on hand and available for sale at any given time.   Merchandise inventory (also called Inventory) is a current asset with a normal debit balance meaning a debit will increase and a credit will decrease.

To determine the cost of goods sold in any accounting period, management needs inventory information. Management must know:

• its cost of goods on hand at the start of the period (beginning inventory)
• the net cost of purchases during the period
• and the cost of goods on hand at the close of the period (ending inventory).

Since the ending inventory of the one period is the beginning inventory for the next period, management already knows the cost of the beginning inventory. Companies record purchases, purchase discounts, purchase returns and allowances, and transportation-in throughout the period. Therefore, management needs to determine only the cost of the ending inventory at the end of the period in order to calculate cost of goods sold.

Cost of goods sold is the inventory cost to the seller of the goods sold to customers.  Cost of Goods Sold is an EXPENSE item with a normal debit balance (debit to increase and credit to decrease). Even though we do not see the word Expense this in fact is an expense item found on the Income Statement as a reduction to Revenue.  

Accountants must have accurate merchandise inventory figures to calculate cost of goods sold. Accountants use two basic methods for determining the amount of merchandise inventory—perpetual inventory procedure and periodic inventory procedure.

When discussing inventory, we need to clarify whether we are referring to the physical goods on hand or the Merchandise Inventory account, which is the financial representation of the physical goods on hand. The difference between perpetual and periodic inventory procedures is the frequency with which the Merchandise Inventory account is updated to reflect what is physically on hand.

Under perpetual inventory procedure, the Merchandise Inventory account is continuously updated to reflect items on hand, and under the periodic method we wait until the END to count everything.

The following video explains the difference between periodic and perpetual inventory methods:

Perpetual inventory procedure:

Companies use perpetual inventory procedure in a variety of business settings. Historically, companies that sold merchandise with a high individual unit value, such as automobiles, furniture, and appliances, used perpetual inventory procedure. Today, computerized cash registers, scanners, and accounting software programs automatically keep track of inflows and outflows of each inventory item. Computerization makes it economical for many retail stores to use perpetual inventory procedure even for goods of low unit value, such as groceries.

Under perpetual inventory procedure, the Merchandise Inventory account provides close control by showing the cost of the goods that are supposed to be on hand at any particular time. Companies debit the Merchandise Inventory account for each purchase and credit it for each sale so that the current balance is shown in the account at all times. Usually, firms also maintain detailed unit records showing the quantities of each type of goods that should be on hand. Company personnel also take a physical inventory by actually counting the units of inventory on hand. Then they compare this physical count with the records showing the units that should be on hand.

Periodic inventory procedure:

Merchandising companies selling low unit value merchandise (such as nuts and bolts, nails, Christmas cards, or pencils) that have not computerized their inventory systems often find that the extra costs of record-keeping under perpetual inventory procedure more than outweigh the benefits. These merchandising companies often use periodic inventory procedure.

Under periodic inventory procedure, companies do not use the Merchandise Inventory account to record each purchase and sale of merchandise. Instead, a company corrects the balance in the Merchandise Inventory account as the result of a physical inventory count at the end of the accounting period. Also, the company usually does not maintain other records showing the exact number of units that should be on hand. Although periodic inventory procedure reduces record-keeping, it also reduces control over inventory items.  Firms assume any items not included in the physical count of inventory at the end of the period have been sold. Thus, they mistakenly assume items that have been stolen have been sold and include their cost in cost of goods sold.