Costs of Goods Sold – Additional Accounting Principles that Businesses With Inventory must know

If you own (or plan to own) a service business that does not sell any products or goods, then the previous blog post is sufficient for your business: 40 Basic Accounting Principles that you must know to understand Small Business Accounting. However, if your business sells products or goods and you’re one of many businesses with inventory, then you need to know some additional information on costs of goods sold (COGS).

Since the article on the three business financials has not yet been posted, we’ll mention here that the Cost of Goods Sold (COGS) is part of both the balance sheet (one of the expense accounts) and the income statement.

On the income statement, the cost of goods sold is listed directly below the sales: Sales – Cost of Goods Sold = Gross Revenue. Gross Revenue is also called gross margin or gross profit. It’s the difference between your wholesale price (the price you pay for the goods) and your retail price (the price you charge your customers for the goods).

What happens when you buy inventory, but you don’t sell it all before the end of the year? If you record it as an expense, then your revenues will appear lower than they actually are because you still have marketable inventory sitting in your storage as an asset. Therefore, the costs of goods sold that appears on your income statement is not simply the cost of goods multiplied by the number of goods that you purchased. It’s actually the result of this formula:

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

Here is an example from the book Financial Accounting: A Mercifully Brief Introduction (adapted):

A business owner buys 100 widgets for $250 each. She sells 100 widgets for $500 each. Her financial statement will show this:

Sales: $50,000
Costs of Goods Sold: $25,000
Gross Profit: $25,000

This is fine if she sells as much as she buys, which doesn’t usually happen. In a different scenario she buys 150 widgets but only sells 100 widgets. Her financial statement would show this:

Sales: $50,000
Cost of Goods Sold: $37,500
Gross Profit: $12,500

However, she still has 50 widgets that she can sell next year. So Cost of Goods Sold must be recalculated using the formula above. Beginning inventory ($0) + Purchases ($37,500) – Ending Inventory ($12,500) = Cost of Goods Sold ($25,000). So her income statement will actually be this:

Sales: $50,000
COGS: $25,000 (not $37,500)
Gross Profit: $25,000

If your wholesale prices never changed, then that’s all you’d need to know. However, no market is so steady and consistent that prices never change. So how do you figure cost of goods sold when you buy 100 widgets at $250 each and 450 widgets at $225 each? In other words, what is the actual price you use for ending inventory in the formula if some of the widgets you sold only cost $225 instead of $250? Some inventory systems are sophisticated enough to actually keep track of exactly what is sold. So even though all your inventory may be stored in the same place, it is recorded item for item, or batch for batch. However, if the inventory gets mixed without a recording system, then you and your accountant will have to make some assumptions or use weighted average cost. Two ways to make assumptions are first in, first out (FIFO) and last in, first out (LIFO). Under the FIFO assumption, ending inventory is associated with costs from the most recent deliveries. Under the LIFO assumption, ending inventory is associated with the oldest purchase costs. The book demonstrates that the choice of which assumption you use can dramatically affect the results of your ending inventory and in turn affect the results of gross profit. You and your accountant must decide which method is best for your business. GAAP allows a business to use any flow assumptions it chooses, as long as the business is consistent.

There are two methods for bookkeeping for inventories, the perpetual method and the periodic method. In the perpetual method, all inventory acquisitions are recorded as asset purchases. The cost of goods sold is not recorded until the inventory is actually sold. In the periodic method, inventory purchases are recorded as an expense. At the end of the accounting period, inventory on hand is counted and an adjustment is made to reflect the ending inventory as an asset. The periodic method is better for businesses that don’t have a sophisticated tracking system for inventory. Yet, it won’t help the business catch or reduce shop lifting or employee theft, or keep track of goods that spoil or expire.

Since the market for goods changes, the value of goods purchased by a business can increase or decrease after they’re purchased. (Yet another reason why accounting doesn’t portray the economic condition of a business with 100% accuracy). GAAP requires that inventory must be carried on the books and reflected on the balance sheet at the lower cost or market value. This means inventory cannot be adjusted up to fair market value, but must be adjusted down when its fair market value declines below its cost. Examples of when fair market value declines below its cost include obsolescence, spoilage and changes in customer preference.

This article was not written by an accountant. Consult with an accountant or other qualified professional to perform accounting for your business.

Major source for this article: Financial Accounting: A Mercifully Brief Introduction by Michael Sack Elmaleh. Buying this book or a similar book would be beneficial to anyone who wants to learn accounting since the end-of-chapter examples and exercises can help to solidify the material in your mind.

For an explanation of why a marketing blog has posts on accounting, read September is Accounting Month.

If you have any questions on this article (or answers to questions), leave a comment below.