Cost of Goods Sold

By Marc Weiss, Managing Director of Management One When reviewing your financial statement there are several key elements that determine profit: 1. Net sales- the amount of sales during the reporting period. This amount reflects the total value of merchandise sold to your customers. Markdowns are subtracted and sales tax is not included in Net Sales. Some other caveats to remember is that gains or losses from investments or from charging customers for alterations are not included in Net Sales. This income is added below as Other Income. Also, Net Sales assume an accrual basis for accounting. For example, if an item is sold on a house charge that item is included in Net Sales even though the revenue has not been fully collected. Should the monies never be collected then that becomes an expense when it is determined uncollectable. 2. Cost of Goods Sold- this is sometimes referred to as Cost of Sales. Cost of Goods Sold is what it actually costs a retailer for the goods that he sold during a given period. The correct formula for determining Cost of Goods Sold for merchandise is: a. Beginning inventory at cost b. +Purchases at cost c. -Ending inventory at cost d. =Cost of good sold Accountants will also include freight-in, as Generally Accepted Accounting Principles requires that this expense directly related to bringing the merchandise available to sell be included. Cash discounts are often also reflected as a separate line item in the Cost of Goods section of the financial statement as a reduction in purchases. This is particularly true for retailers who include discounts when determining initial mark up. Generally Accepted Accounting Principles for publicly held companies requires that

they be reflected as a credit expense or other income as a line item on the income statement. In smaller companies cash discounts and incentives are immaterial and their placement on the financial statement is at the discretion of the owner. It is important that whatever is included be consistent over time. 3. Gross Profit- Net Sales minus Cost of Goods Sold. This is the money that is available to pay other expenses, bills, salaries, taxes and profits. 4. Total Operating expenses- A list of all your expenses- occupancy, salaries, selling, general and administrative expenses. A dividend or distribution that the owner takes is not included in operating expenses. 5. Net Profit/(Loss)- Gross Profit minus operating expenses. This is what is available for dividends, debt reduction, or dollars to reinvest in the business. Sometimes financial statements will calculate Cost of Goods Sold strictly as purchases for the period. It is not quite that simple. Cost of Goods Sold is based on goods available for sale during the period that is being reported. Goods available for saleincludes beginning inventory as well as merchandise purchased during the period reviewed. Simply stating purchases instead of an accurate Cost of Goods Sold calculation does not take into account beginning and ending inventory. For example, merchandise theft impacts profits by raising Cost of Goods Sold. The merchant pays for goods whether they are stolen or given away. This is reflected in the difference of beginning and ending inventory and the accurate reflection of these transactions would boost the Costs of Goods Sold. Showing only purchases as Cost of Goods Sold distorts the profit and would result in decisions, like income taxes to pay on a less accurate measurement.

How inventory is valued with the different acceptable methods, like LIFO, FIFO, or Average Cost can have a direct impact on your financial statement. (We will examine this in greater detail in our November issue). The accuracy of your financial statements Cost of Goods Sold should be gauged each time you review it by examining the related percentages in comparison to prior periods and your knowledge and experience. Reflecting Cost of Goods Sold accurately on a financial statement is critical to its overall accuracy. The first litmus test on the accuracy of a financial statement is the Cost of Goods Sold. Its accuracy provides the level of confidence in the exactness of the overall bottom line. Here is a short list that can go wrong: Inventory Valuation Cut off procedures for purchases to collect all receiving within a given period Omission of purchases awaiting invoices from vendors Returns of merchandise to vendors or from customers not recorded or included. Net sales not recorded due to different procedures like lay-a-way and special orders. Unrecorded transactions for transfers of merchandise Unrecorded invoices for merchandise Overages, Shortages, or theft unrecorded Promotional sales not recorded when sold Gift certificates, payments in advance, or credit not posted or not recorded correctly. Damaged merchandise not reflected Sales tax included inaccurately.

This November we will be taking a look at inventory valuation in greater detail. The timing of this information comes at a critical time in managements decisions to use correct valuation decisions for year-end statements that could benefit tax situations.
Copyright Management One 2004