Merchandise Inventory Explained Simply (With Examples and Best Practices)

Merchandise inventory is the total value of goods a business has purchased for resale but hasn’t sold yet. It includes items sitting on store shelves, in the stockroom, or transit—if the business owns them, they count.

This inventory is more than just a list of products. It’s a key asset that affects your profit, cash flow, and how you report financials. It sits on the balance sheet as a current asset and directly connects to the cost of goods sold (COGS) on the income statement.

Understanding how merchandise inventory works helps business owners:

• Price products more accurately
  
• Avoid stockouts or overstock
  
• Report correct financial data
  
• Improve profit margins
  

If you run a retail or e-commerce business, tracking merchandise inventory is not optional. It’s one of the first things that accountants look at—and one of the biggest reasons behind inaccurate books when done wrong.

Key Components of Merchandise Inventory

Merchandise inventory includes more than just the products on your shelves. If your business buys goods to resell, all unsold items you legally own are part of your inventory. Here’s what that includes:

Items Held for Sale

These are the products you’ve bought from suppliers and are ready to sell. They can be sitting in your store, warehouse, or online fulfillment center. If you’ve paid for them and they’re unsold, they count.

Goods in Transit

If you’ve purchased items and they’re on the way from the supplier, but ownership has already transferred, they’re still part of your inventory. This depends on your shipping terms (like FOB shipping point vs. FOB destination).

Returned Merchandise

Items customers return may go back into inventory if they’re in resellable condition. If not, you may need to write them off.

Damaged or Obsolete Stock

Still technically part of merchandise inventory until removed or written down. It’s best to review and adjust for this regularly.

Promotional Stock

Items held for giveaways, discounts, or bundles can still count as inventory until used or sold.

How Merchandise Inventory Works in Accounting

Merchandise inventory shows up on your balance sheet as a current asset. It represents products you’ve paid for but haven’t sold yet. Once a sale happens, the cost of that item moves to the income statement under the cost of goods sold (COGS).

Here’s how it flows:

1. You buy inventory. → it goes on the balance sheet as an asset.
   
2. You sell inventory → its cost moves to the income statement as COGS.
   
3. You profit → The difference between sales revenue and COGS is your gross profit.
   

This movement helps match the cost of the product to the revenue it generates—this is called the matching principle in accounting.

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A Quick Example:

You buy 100 shirts at $10 each → merchandise inventory = $1,000.

You sell 20 shirts at $20 each:

• COGS = 20 × $10 = $200
  
• Revenue = 20 × $20 = $400
  
• Gross Profit = $400 – $200 = $200
  

The remaining 80 shirts stay on your balance sheet as inventory worth $800 until sold.

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Accurate inventory accounting gives you:

• Real profit visibility
  
• Correct tax reporting
  
• Better inventory control
  

If inventory is overstated or understated, your profit and taxes will be, too. That’s why clean, consistent tracking is key.

Inventory Costing Methods

Not all inventory costs the same over time. Prices change, and so do purchase dates. That’s why businesses use costing methods to figure out which inventory costs to match with sales.

These methods don’t change your actual stock, but they do affect your profit and taxes. Here are the most common ones:

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1. FIFO (First-In, First-Out)

In FIFO the first items you buy are the first ones counted as sold.

• Used when prices rise.
  
• COGS is lower, profit looks higher.
  
• Ending inventory is based on the most recent costs.
  

Example:
You buy 100 units at $5, then 100 at $6.
You sell 100 → FIFO assigns the $5 units to COGS.

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2. LIFO (Last-In, First-Out)

The last items you buy are the first ones counted as sold.

• Used when prices rise.
  
• COGS is higher, profit looks lower (less tax).
  
• Ending inventory is based on older costs.
  

Example:
Same purchase as above.
You sell 100 → LIFO assigns the $6 units to COGS.

Note: LIFO is allowed under U.S. GAAP but not under IFRS.

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3. Weighted Average Cost

Spreads cost evenly across all units.

• Simple and stable.
  
• Works best when inventory items are similar in cost.
  

Example:
100 units @ $5 + 100 units @ $6 = 200 units @ avg. $5.50
You sell 100 → COGS = 100 × $5.50 = $550

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4. Specific Identification

Track the exact cost of each item sold.

• Used for high-value or unique items like cars or jewelry.
  
• Most accurate, but requires detailed tracking.
  

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Your chosen method affects:

• Gross profit
  
• Inventory value
  
• Tax liability
  

Most businesses stick with one method for consistency. Talk to your accountant before switching.

How to Track Merchandise Inventory Accurately

Tracking inventory is about knowing what you have, what you’ve sold, and what it’s worth. Mistakes here can lead to lost sales, cash flow issues, or inaccurate financials.

There are two main systems to track merchandise inventory:

Periodic Inventory System

You count inventory at the end of a set period—monthly, quarterly, or yearly.

• No updates during the period
  
• Sales recorded without updating inventory
  
• COGS is calculated at the end:
  COGS = Beginning Inventory + Purchases – Ending Inventory
  

Best for: Small businesses with low volume or simple inventory.

Perpetual Inventory System

Inventory updates automatically with each sale or purchase.

• Real-time tracking
  
• Sales instantly reduce inventory count
  
• Integrates with POS and accounting software
  

Best for: Retailers with high volume or multiple sales channels.

Tips to Keep Inventory Accurate

• Use inventory software — Reduces manual work and errors
  
• Do regular stock counts — Spot-check or cycle count often
  
• Update for returns and damage — Keep records clean
  
• Train staff — Mistakes happen when people don’t follow the process
  
• Set reorder points — Avoid running out or overstocking
  

Accurate tracking helps you make better decisions, reduce waste, and stay profitable. Whether you’re using spreadsheets or an advanced system like ArmPOS, the goal is the same: know your numbers, always.

Best Practices for Managing Merchandise Inventory

Managing inventory isn’t just about keeping stock on shelves—it’s about having the right items, in the right amounts, at the right time. Good inventory habits keep your cash flowing and your customers happy.

Here are key practices that make a big difference:

Organize Your Storage

• Group similar items together
  
• Label shelves and bins clearly
  
• Use barcodes or QR codes for faster scanning
  

This saves time and reduces picking errors.

Track Inventory in Real Time

• Use inventory management software
  
• Sync it with your POS and accounting tools
  
• Automate reorders when stock gets low
  

Real-time tracking helps you act before problems grow.

Audit Inventory Regularly

• Do monthly or quarterly stock checks
  
• Compare system records to physical stock
  
• Fix any gaps fast
  

Spotting issues early keeps your data reliable.

Forecast Demand

• Look at past sales patterns
  
• Watch seasonal trends
  
• Adjust orders based on real demand
  

Forecasting helps you avoid both stockouts and overstock.

Use Reorder Points and Safety Stock

• Set minimum levels for each item
  
• Keep a buffer for unexpected demand
  

This keeps your shelves stocked without tying up cash.

Train Your Team

• Teach proper receiving and recording steps
  
• Make sure staff updates stock immediately
  
• Keep everyone on the same page
  

Inventory is only as accurate as the people managing it.

Smart inventory management keeps your business efficient and your customers coming back. Small steps, done consistently, lead to big savings and smoother operations.

Merchandise Inventory Example (Simplified)

Let’s say you run a small electronics shop. Here’s a quick example to show how merchandise inventory works:

Beginning Inventory:

• 10 Bluetooth speakers at $50 each
  
• Total value = $500
  

Purchases (During the Month):

• Bought 20 more speakers at $55 each
  
• Purchase cost = $1,100
  

Total Available Inventory:

• 10 (old) + 20 (new) = 30 speakers
  
• Inventory value = $500 + $1,100 = $1,600
  

Sales (During the Month):

• Sold 25 speakers
  
• You need to calculate the cost of the 25 sold units
  (This depends on your inventory method: FIFO, LIFO, or Average)
  

Using FIFO (First-In, First-Out):

• First 10 speakers sold at $50 = $500
  
• Next 15 sold at $55 = $825
  
• Total COGS = $500 + $825 = $1,325
  

Ending Inventory:

• 5 speakers left, all from the latest batch
  
• 5 × $55 = $275
  

This example shows how you track inventory, purchases, and sales to calculate:

• Cost of Goods Sold (COGS)
  
• Ending inventory balance
  
• Profit from the sale
  

By keeping simple records like this, you’ll always know what’s in stock and what it’s worth.

Conclusion

Merchandise inventory is more than just products on shelves—it’s money tied up in goods you plan to sell. Knowing how to track, value, and manage it helps you make smart business decisions, reduce losses, and keep operations running smoothly.

Good inventory habits protect your profits, whether you’re a small shop or a growing retailer. Use simple tools, follow clear systems, and stay consistent. When you understand your inventory, you stay in control of your business.