When does the cost of inventory become an expense?
It’s a question that can create confusion for business owners, so we wanted to take a couple of minutes and help you make sense of it. In order to fully unpack this question, we first need to clarify the difference between a “cost” and an “expense.”
Cost vs Expense
A purchase is classified as a “cost” when it is something that is related to an asset. It’s an “expense” when it is related to the ongoing operations of a business.
For example, if you own a retail business of some kind and you buy a new building. That purchase is a cost, and it is listed among the items of value (assets) that your company owns.
On the other hand, if your retail business needs to purchase pricing stickers to put on the new shipment of widgets you just got in, that is an expense. It’s something you do in the normal course of business in order to sell your widgets.
What Is the Difference Between Inventory and Supplies?
Another way to look at whether or not something is a cost or an expense is to consider the difference between “inventory” and “supplies”.
When we talk about inventory in accounting, we’re referring to the things that are involved with whatever it is you are ultimately selling to your customer. This can include ready-to-go items that you bought at wholesale and are simply reselling at retail. Or inventory can be the raw materials or anything used to create the final product that you then sell to your customers.
As we’ll see in a moment, this inventory is initially an asset. That changes once you sell it.
Supplies, on the other hand, are things associated with the normal day-to-day operations of your business. Your paperclips, pens, and the K-cups in your breakroom aren’t directly associated with the widget you’re handing to customers. Therefore, they get treated differently. With supplies, you are the end user.
Depending on your business, it is possible to be in a situation where you are buying both inventory and supplies from the same vendor. For instance, if you run a printing company, you routinely staple pages together for customers. You also likely staple a lot of internal documents together that get filed away in your office. Same staples…two different uses showing up in two different places in your financials.
How you categorize these things affects your taxes as well. Because you are eventually passing inventory items along to your customer, sales tax is not applied until someone buys them from you. You pay sales tax, however, on supplies you use because there is no one next in line to pass that tax along to.
Chron.com also has a good article on the difference between supplies and inventory that goes into further detail.
When Does the Cost of Inventory Become an Expense?
As the retail store owner in our example, you regularly purchase new widgets in order to then sell them to the public. Those widgets are something of value, like the building you bought. But at the same time, widgets are a necessary ongoing part of the operations of your business. (If you didn’t have them…you wouldn’t be in business!)
So the next logical question then becomes “when does the cost of inventory become an expense?”
Inventory becomes an expense when the product is sold. As soon as a customer gives you money in exchange for that item, it moves from the category of an “asset” to become an “expense” on your income statement.
Up until that point, it is something the business owns. But once someone buys it, you can then calculate the Cost of Goods Sold (COGS) in order to determine how much profit you made by selling it.
COGS is basically whatever it takes in order to get that product ready to sell. That can include raw materials or ordering costs, packaging, storage, etc.
Where Is Inventory Reported in the Financial Statements?
Since inventory is an asset, it is reported in the asset section of your company’s balance sheet.
Once the item leaves your business, it is no longer part of your inventory. That change in inventory is what then gets reported as a COGS entry on your income statement.
How to Calculate the Cost of Goods Sold
The standard equation for calculating COGS is:
Beginning inventory + Purchases = Cost of Goods Available – Ending Inventory
Here’s an example: If your beginning inventory was $1,000 and you then purchased $500 of additional inventory, your Cost of Goods Available would be $1,500. If your ending inventory was $200, your COGS for that period would be $1,200.
The inventory that was once listed as an asset on your balance sheet, after it has sold, is later represented as a $1,200 COGS on your income statement.
From Inventory Expense to Everything Else Accounting…We’ve Got You Covered
We get it. Questions like “what’s the difference between inventory and expense” can get confusing. That’s why we’ve spent the past 40+ doing what we do. Providing Monthly Bookkeeping Services is just one of the ways we help you keep things in order.
When it comes to the tough questions about accounting, we enjoy getting to help small business owners just like you make sense of it all. We believe you deserve to expect more from your CPA.
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