Inventory, often called stock, is the goods a business holds to sell. It is a simple idea, but it plays an important part in working out profit.

Understanding opening and closing inventory early makes the cost of sales calculation, which many students find fiddly, much easier. By the end of this page you will see why unsold goods change the profit a business reports.

What inventory is

Inventory is the goods a business has bought (or made) to sell to customers but has not yet sold. A shop’s shelves and a warehouse of products waiting to be sent out are inventory. It is a current asset, because the business expects to turn it into cash fairly soon.

It helps to notice what is not inventory. A delivery van, a computer or shop fittings are not inventory, even though the business owns them. They are kept to help run the business, not to be sold.

The same item can be inventory in one business and equipment in another. Shelving is inventory for a supplier that sells shelves, but equipment for the grocer who bolts them to the wall. What matters is the purpose the goods are held for.

Opening and closing inventory

At the start of a period, a business usually already holds some unsold goods carried over from before. This is the opening inventory. At the end of the period, some goods are still unsold.

This is the closing inventory. This year’s closing inventory becomes next year’s opening inventory, so the two link year to year.

Imagine a small stationery trader that ends its first year with RM4,000 of unsold notebooks and pens. That RM4,000 is its closing inventory for year one. When year two begins, those same goods are still there waiting to be sold, so RM4,000 becomes the opening inventory for year two.

Nobody buys them again. They carry across the join between the two periods. Because of this chain, an error in one year’s closing figure becomes an error in the next year’s opening figure too.

Why unsold goods affect profit

Only the goods actually sold should count as a cost against this period’s sales. Goods still unsold at the year end are not a cost yet, because the business still has them.

So when working out the cost of goods sold, we add the opening inventory and purchases, then take away the closing inventory. This is the matching principle. We set the cost of goods that were sold against the sales they earned, and hold back the cost of goods not yet sold.

The cost of sales formula

Put simply: cost of sales = opening inventory + purchases − closing inventory. If you buy a lot but sell little, closing inventory is high and cost of sales is low.

More of your spending is carried forward as an asset and is not charged against this year’s profit. That is why counting closing inventory correctly matters so much.

A worked example

A small shop starts the year with opening inventory of RM5,000. During the year it buys a further RM30,000 of goods to sell.

At the year end, a count of the shelves and stockroom shows RM8,000 of goods still unsold. The cost of sales is:

RM5,000 (opening) + RM30,000 (purchases) − RM8,000 (closing) = RM27,000.

Although the shop spent RM30,000 on purchases, only RM27,000 counts as a cost this year, because RM8,000 of goods have not been sold. If sales for the year were RM45,000, gross profit is RM45,000 − RM27,000 = RM18,000.

Now suppose a more careful count had found RM10,000 of closing inventory. Cost of sales would fall to RM25,000 and gross profit would rise to RM20,000. The shop bought and sold exactly the same goods.

Only the closing count changed, yet the reported profit moved by RM2,000. That shows how directly the closing figure feeds into profit.

Valuing inventory carefully

Inventory is valued at what it cost, not at its selling price. Profit is only earned when the goods are sold, not while they sit on the shelf.

If goods have lost value and could only be sold for less than they cost, they are valued at the lower figure. This is the prudent approach.

For example, a batch of goods cost RM2,000 but fashion has moved on and it could now only be sold for RM1,200. We value it at RM1,200 and accept the fall now, instead of pretending the goods are worth their full cost. For now, remember the rule: normally value inventory at cost, but never above what it could realistically sell for.

A common beginner slip

Students often forget the closing inventory, or add it instead of subtracting it, when working out cost of sales. A quick sense-check helps.

Unsold goods are still owned by the business, so they should reduce the cost charged this period. If your answer treats unsold goods as a cost, something has gone wrong.

Another common mistake is valuing inventory at selling price to make it look more valuable. Avoid this, because it would report profit before the goods are sold.

How it all connects

Inventory links purchases, sales and profit. It also appears in the statement of financial position as a current asset.

Closing inventory does two jobs: it lowers the cost of sales in the income statement and appears as an asset the business still owns. Getting comfortable with opening and closing inventory now gives you a firm base for the income statement, because the same figures keep returning.

If cost of sales still confuses you, one of our teachers can work through it with a few simple examples, one step at a time. Book a trial class.