---
title: "Inventory and Cost of Goods Sold"
sidebarTitle: "Inventory and COGS"
description: "What inventory is, how a physical inventory count works, and how count adjustments flow through to COGS and the income statement."
icon: "boxes-stacked"
---

> **For AI agents:** the complete documentation index is at [llms.txt](/llms.txt). Append `.md` to any page URL for its markdown version.

| Field | Value |
|---|---|
| **Owner** | Unassigned — needs an owner |
| **Department** | General Accounting |
| **Effective date** | Not set in source |
| **Scope** | Background on inventory categories, the physical inventory count process, and how count adjustments affect COGS and inventory valuation. This is reference material rather than a step-by-step PBI procedure. |
| **Source** | `General Accounting/04 - Inventory and COGS/Inventory.docx` |

<Note>
  This page is **conceptual background**, not a PBI operating procedure. The source library's `04 - Inventory and COGS` folder contains this concepts document and an example spreadsheet but **no process document, balance sheet rec, or responsibility split**. A PBI-specific inventory procedure is an open gap.
</Note>

Inventory is the goods and materials a business holds for resale or production — the stock of products or raw materials a company owns and intends to sell to customers or use in manufacturing.

## Inventory categories

| Category | Description | Examples |
|---|---|---|
| **Finished goods** | Fully manufactured or assembled products ready for sale | Electronic devices, clothing, furniture, packaged food |
| **Raw materials** | Basic materials or components used in production | Wood, steel, plastic, fabric, chemicals |
| **Work-in-progress (WIP)** | Partially completed products in various production stages — inventory that has incurred costs but is not finished | — |
| **Goods-in-transit** | Inventory in transit between supplier and company facilities, or between facilities and customers | Inventory moving by truck, ship, train, or air |

Inventory is a significant asset for many businesses and represents a substantial investment of capital. Effective management optimizes cash flow, minimizes carrying costs, and ensures the right products are available to meet demand. Common techniques include just-in-time (JIT) inventory systems, economic order quantity (EOQ) models, and ABC analysis.

## The physical inventory count

An inventory count — also called a physical inventory count or stocktake — physically counts and verifies the quantity of goods held at a specific point in time. Its purpose is to confirm that the quantity recorded in the accounting records matches the actual physical inventory on hand.

<Steps>
  <Step title="Preparation">
    Plan before counting: organize the inventory area, assign teams or personnel to perform the count, and obtain the necessary counting tools such as scanners, tally sheets, or barcode readers.
  </Step>

  <Step title="Counting">
    Teams physically count the quantity of each item, by hand or using electronic devices, moving through the inventory locations and recording the count for each item.
  </Step>

  <Step title="Recording">
    As items are counted, quantities are recorded on count sheets or entered directly into the inventory management system.

    <Warning>
      Accurate recording at this stage is what prevents discrepancies between the physical count and the recorded balances. An error here becomes an adjustment that hits COGS.
    </Warning>
  </Step>

  <Step title="Verification">
    Once counting is complete, verify the counts for accuracy and completeness — cross-check counts between different teams, resolve discrepancies, and conduct recounts if necessary.
  </Step>

  <Step title="Adjustments">
    If discrepancies exist between the physical count and the recorded balances, adjust the inventory records — updating quantities in the accounting system to reflect the actual physical count.
  </Step>

  <Step title="Reporting">
    Prepare a final inventory report summarizing the results of the count, including any discrepancies, adjustments, and recommendations for improving inventory accuracy in future counts.

    **Expected outcome:** recorded inventory quantities match the physical count, with every adjustment documented and explained.
  </Step>
</Steps>

Counts are typically conducted periodically — annually or quarterly — to ensure the accuracy of inventory records and comply with regulatory requirements. They are essential for accurate financial reporting, controlling inventory shrinkage, and optimizing inventory management.

## How a count affects the income statement

An inventory count does **not** directly affect the income statement. Its impact is indirect, through cost of goods sold and inventory valuation.

<AccordionGroup>
  <Accordion title="Cost of goods sold (COGS)">
    COGS represents the direct costs of producing or acquiring the goods sold during a period. When inventory is counted, the quantity on hand is verified, which can change the COGS calculation.

    If the physical count reveals discrepancies against the recorded balances, adjustments correct the inventory records — and those adjustments affect COGS, potentially changing gross profit and net income.
  </Accordion>
  <Accordion title="Inventory valuation">
    Inventory is typically valued on the balance sheet at the **lower of cost or market value**. Discrepancies identified during a count may require adjustments to bring inventory balances in line with the actual physical inventory.

    These adjustments change the valuation of inventory on the balance sheet, which in turn affects COGS and net income.
  </Accordion>
</AccordionGroup>

In summary: the count itself doesn't hit the income statement, but the adjustments resulting from it affect COGS and inventory valuation — and therefore financial performance and net income. Conduct accurate counts and make any necessary adjustments promptly to keep financial reporting reliable.

## Where COGS shows up in period-end review

Negative or unusual COGS is one of the specific things to check when reviewing the income statement at period end:

- **Negative COGS lines** could indicate either a miscount of inventory or missing invoices that need to be accrued.
- **Large period-over-period COGS% variances** should be investigated for prior period invoices posting in the current period, large inventory adjustments, or an unusual invoice count for the period.

See [Financial analysis](/internal/sops/accounting/general/financial-analysis) for the full review procedure.

## Related documents

- [Financial analysis](/internal/sops/accounting/general/financial-analysis) — the COGS checks performed during period-end review
- `Inventory and COGS Example.xlsx` — see [Supporting materials](/internal/sops/accounting/supporting-materials)