Explain the concept of inventory in income statement



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Explain me in brief the concept of increase in inventory and decrease in inventory in the income statement. which one is added and which one is deducted and why?

1 Answer(s)


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Siddharth, As you probably know, Inventory is typically a balance sheet item (ending inventory balance) or a cash flow item (change in inventory). However inventory is also used in the calculation of Cost of Goods sold in the Income Statement through this formula: Net Purchases +/- Change in Inventory = cost of Goods Sold or more intuittively Begining Inventory + Net Purchase - Ending Inventory = Cost of Goods Sold.

In case Ending Inventory has increased then Net Purchases is reduced in the Income statement, since not all of the net purchases is going towards this periods sales.

Assume in our Pizza example your 2010 Inventory Balance is Rs.10,000, your 2011 inventory purchases is Rs.7,000 and your 2011 Ending Inventory is Rs. 5,000.

Then your Cost of Goods Sold (COGS) = 7,000 (net purchase) + 5,000 (change in inventory form 2010 to 2011) = Rs.12,000. Intuitively, how much raw materials you have used for making pizzas = how much raw materials you bought + how much your existing raw materials reduced.

In case 2011 Ending Inventory was Rs.15,000, then your 2011 COGS = 7,000 (net purchase) - 5,000 (change in inventory) = Rs.2,000. Intuitively, how much raw materials you have used for making pizzas = how much raw materials you bought - how much your existing raw materials increased by.

Hope this answers your question. Please let me know if you would like more clarifications on this topic.