Before we begin, let’s review the various types of inventory and the inventory equation. For a merchandising firm, the inventory is usually the finished goods which they store for sale. For manufacturing units, the inventory will be in the form of raw material, work-in-progress, and finished goods.

At the beginning of the financial year, a firm will have certain inventory with it. This is the beginning inventory. Then the firm will make purchases during the year, and some goods will be sold during the year. At the end of the year, the firm is left with some inventory. This is the ending inventory. A firm will use one of the inventory valuation methods, as we will discuss later, to calculate the cost of goods sold (COGS) and the cost of ending inventory. This can be expressed in the form of a simple accounting equation as follows:

Note that there are four variables and you can rearrange this equation to calculate any of these variables.

Cost of Goods Sold (COGS) is reported in Income Statement and Ending Inventory is reported in Balance Sheet.