Removing the mystery of "Cost of Goods Sold"

Options for determining this very important number

There have been a sizable number of financial statements from dealers that I have reviewed over the past few months. (Yes, I know I do need a hobby.) My concern continues to be the same; statements in a format that few dealers can understand and few dealers that understand any of the information that is on the statement.
It does not help that the information has errors. With a dealer that is unable to understand their financial statement, they are unable to see the errors. They think it is only their lack of knowledge that is the issue.

While there are plenty of concerns we will discuss at another time, the issue that concerns me the most is that of the "cost of goods sold". No matter how accurate we are with other information, it is impossible to know how much money the business has made without the cost of goods sold being correct.

The first hint to a dealer that something is wrong is their having an income statement (also referred to as profit and loss statement) that shows them making money month after month, and their having a checking account that says there is no money.

Let’s get rid of that lack of understanding today with an explanation of how the information should be properly collected and stated. If you attempt to discuss this with your accountant and the accountant is unable to give you an explanation that you can understand, also give me a call.

The cost of goods sold on a monthly income statement is a dollar amount that shows you, in relation to what you have sold during the month, how much that sold inventory did cost you. In addition to the sales and cost of goods sold, the income statement should also list your gross profit. The gross profit, stated as a dollar amount, should then be stated as a percentage.

Let’s start with an example of selling one item. If you sell something for $10 and your cost of that item (this could also be called the cost of the good sold) is $6, then the gross profit is $4. The gross margin is calculated by dividing the $4 of gross profit by the $10 sales price, giving you an answer of 40%. And as long as you sell the item for more than what you paid for it, your gross margin must be a positive number!

Now think of that exercise on a larger scale. Instead of one item, sales is the total of all the items sold in your shop over the course of the month. The sales amount now includes lots of items with varying margins.  Hence, the calculation of  ‘cost of goods sold’ will take a bit more effort to determine.

However, the cost of goods sold is still the cost of the merchandise that you have just sold; nothing more and nothing less. And the math of dividing the gross profit by the gross sales remains the same.
Perhaps you have a point of sale system. If you have been diligent with entering the items you offer for sale, being sure to include the cost for each item, then the point of sale is calculating the cost of goods sold for each item as a sale is completed.

However, if you do not have all of the individual items in your point of sale system, with each sale you are likely ringing up items as ‘miscellaneous’. In this situation, somewhere within your point of sale system, ‘miscellaneous’ has been given a predetermined gross margin. While that will allow the system to do the calculation, the point of sale does not know exactly what is being rang up.

Think about the lowest margin item you have in your business as well as the highest margin item. If the low margin item sells for $4,000 and the high margin item sells for $50, your point of sale system is assigning the same margin to each as you ring up ‘miscellaneous’. At the end of the month, with a sizable ‘miscellaneous’ category on your POS, your margin is ‘highly likely’ to be incorrect.

The second option for determining the ‘cost of goods sold’ occurs in this format. At some point in time, you have taken a complete physical inventory of your business. Most likely the inventory is taken using the retail price of each item, determining a margin for the entire store, and then multiplying to determine your inventory at cost. As an example, you determine you have $500,000 in inventory and a gross margin of 40%. If the gross margin is 40%, then the cost of the inventory is 60%. Multiply the $500,000 by 60% and your answer is $300,000 in inventory at cost.

In our example, we have now stated that the business has $300,000 in inventory at cost as we open the business on the first day of the month. During the month, the shop receives $40,000 in inventory at cost. Notice this is inventory received; it is not the amount of inventory ordered nor is it the inventory for which checks have been written. If we sell nothing during the month, our inventory will be $340,000 at cost at the end of the month and our cost of goods sold will be zero.

However, the business does make sales totaling $65,000 at retail. A second counting of inventory at the end of the month determines there is $302,000 at cost. The shop has sold $38,000 of inventory at cost for some $65,000 that the shop took in. Now repeat the exercise we did initially. $65,000 minus $38,000 equals $27,000. The $27,000 is the gross profit for the month. Divide the $27,000 by $65,000 and the answer is 42%. This is the gross margin for the shop for the month.

As you operate the shop from month to month you should expect that there will be some variation from the 42%, but not by a large amount. Something is wrong with the calculations if the margin is 42% one month, 25% the next month, and 75% a third month. And as long as you are selling the inventory for more than what you paid for it, it is impossible for you to have a negative gross margin!

It is not likely that you are going to be taking a physical inventory of the entire shop every month, so you allow the inventory level to be determined by your point of sale system or by estimating using your gross margin number from previous months or years.

One last component; when you do take a physical inventory you should compare that ‘inventory on hand’ amount with what your point of sale system and your balance sheet says you have. If the ‘inventory on hand’ is less than what should be there, the discrepancy occurs because there have been errors in how the inventory is counted, how the inventory has been tracked since the last inventory, or because of theft.

If your inventory on hand is higher than what your balance sheet says you have, the discrepancy is because of errors in counting or tracking.  (Surely, no one is bringing inventory to your shop and just putting it on your sales floor).

If you simply adjust the cost of goods sold to reflect this discrepancy, you are going to affect your gross margin. A negative difference in inventory is going to cause your gross margin to increase. With the increase in gross margin, you are going to report a higher profit which may or may not be the case.

If the negative difference is believed to be due to theft/shoplifting, then the cost of goods should not be adjusted. Instead, the amount of theft/shoplifting should be an expense. Reporting this loss as an expense will decrease your profit and tax liability. If you cannot determine how the discrepancy occurred, you should visit with an accounting professional to make a decision.

This article is written and shared by Tom Shay to provide insight to how your financial statements are created as well as to assist you in having a conversation with your accountant and attorney. As I am not a tax or legal professional, the information should not be taken as advice. Decisions about your business should be made by you and competent professionals that you understand and have confidence in.

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