Cost of Goods Sold


The Cost-of-Goods-Sold Formula
"How do you compute cost-of-goods-sold?" That question suggests that there might be several choices in the same way that there is cash accounting, accrual accounting and hybrid methods. However, there is only one method of computing the cost-of-goods-sold. The formula is:


Beginning Inventory
+ Purchases
- Ending Inventory
= Cost-of-Goods-Sold


We usually write it in a shorthand fashion: B + P - E = C We can also show the computation as a worksheet:

1. Enter the beginning inventory.

1.________________________

2. Add up the purchases and enter.

2.________________________

3. Add line 1 and line 2. This is the amount "available for sale."

3.________________________

4. Enter the ending inventory.

4.________________________

5. Subtract line 4 from line 3. This is the cost-of-goods-sold

5.________________________
The Myth of Retail Accounting
The important thing that the formula does not clearly state in this: we must use the cost or wholesale values of all three elements; the beginning inventory, purchases, and ending inventory. From time to time I have heard this idea of "retail accounting." The implication is something like, "Hmm. I did not make much of a profit figuring it on cost, so what if we used 'retail accounting.'" Most likely the idea began years ago when the managers of retail outlets filled out weekly or monthly reports that were sent to the home office. The managers took inventory at retail. A week or so later they got a report stating what the profit was. The managers assumed that the calculation was done using unadjusted retail figures. It does not work that way, but I admit that there is a problem that requires an adjustment.

Adjusting Inventory
Usually we begin our work with this set of facts:
  1. Last month's ending inventory at cost
  2. Invoices for purchases during the month
  3. Ending inventory at retail
We must change the ending inventory at retail so that it is ending inventory at cost. To do that, we multiply it by a factor. For example, if the retail inventory is $6,000 and items in that category average a 30% Gross Profit Margin, then we multiply $6,000 by 70% [100% - 30% profit = 70% cost]. So, $6,000 times 70% is $4,200. We use $4,200 as the ending inventory.Sometimes I hear the phrase "discounting the inventory" used when multiplying it by a factor. I do not like to use that phrase here because it really means something else quite different. For example, let's say that a Seller is selling his business to a Buyer. Buyer and Seller agree to multiply the $10,000 retail inventory by a factor of 70% to get the cost. Buyer and Seller agree that the cost should be considered as $7,000. But the Buyer points out some defects in the inventory. In order to make the sale go through, the Seller agrees to further discount the inventory 10% and settles on $6,300.

"Problems" with Using Factors
Sometimes I hear two objections to using a factor:
  1. What about stolen merchandise?
  2. What if the factor is wrong?
The answer to the stolen merchandise question is simple. All we want to know is the value of the ending inventory. Stolen merchandise is not part of ending inventory.The best way to answer the second is to demonstrate by example that a 5% difference does not have much effect on the total over-all information.

USE 70%

USE 75%

Sales

$12,000

$12,000

Beginning inventory at $8,000 retail

$ 5,600

$ 6,000

Purchases

$ 7,000

$ 7,000

Ending inventory at $5,000 retail

$ 3,500

$ 3,7500

COGS

$ 9,100

$ 9,250

Gross Profit

$ 2,900

$ 2,750

Gross Profit Percentage

24%

23%
What COGS Tells Us
There are several things that the Cost-of-Goods tell us:
  1. We can compare your store to to other similar stores and regional and national averages.
  2. We can detect theft.
  3. We can more accurately see the profitability of the whole store.

top