You have inventory on your balance sheet and it’s measured in its lower of cost or net realisable value. It increases as you buy items and once you write something down, it decreases in value. That’s the easy part.

However, once you start expensing it onto income statement (the third way inventory decreases), that’s where the fun starts. Well, fun or tricky part to say the least. Why is it so? Let me first explain. Say you’ve bought the same item with different prices, say 10 and 12 – on your inventory listing you have 1 item with the price of 10 and the other with 12, totalling to 2 items worth for 22.  What happens if you sell one of them? 

Question then is which one did you exactly sell. If your inventory is small, it’s probably not a question but if you make numerous sales per day it’s really hard to keep track on which specific item did you sell, was it the one that cost you 10 or 12?

One of the methods to expense items of inventory when they are sold is using the average method (average of the purchase prices the items were accounted into inventory). Nothing changes on the inventory account, but as you can see from our example, the average price of the item is 11 and this 11 is something you’d account as “cost of goods sold” on the income statement at the time of the sale.

Your accounting entry (excluding revenue entry from the sale):

Db Cost of goods sold 11

Cr Inventory 11

The remaining inventory level is 11 and once you sell the other item, it’s 0. It may seem that the average cost disregards the actual cost and there would be something left into inventory once you sell all your items, but once you think about how the method works, it cannot happen.