In today’s post, I want to talk about Cost of Goods Sold. It is very important to understand this concept as doing it wrong can have dramatic impact to your bottom line.
Cost of Goods Sold (COGS) is a special type of expense account: If you sell product, this is the cost related to your gross income and varies by the amount of sales. Be careful here!! I have seen a lot of retailers and even their bookkeepers think that COGS is what you have paid for your inventory. That is not true. When you buy inventory, you are exchanging one asset (cash) for another (inventory). You only incur the cost when you actually sell the product. That whole discussion can be an article all in itself, but knowing the difference makes a huge impact to your bottom line, just remember it is Cost of Goods SOLD, NOT PURCHASED.
Consider the example of the retailer who is stocking up for the holiday season. They order and pay for $100k worth of merchandise. They now have 100k of inventory sitting in the storeroom plus whatever they had in stock prior to the order. Consider if their sales for the month were $150k for the month so if you took the expense at time of purchase, the Gross Profit would be $50k. Now consider if they normally sold their product for twice what they bought it for, in this case, the COGS would be 75k or a difference of 25K. The other problem is that by posting the inventory purchase to an expense, you will not have a true value of your inventory
This is a very simple example, but you get the idea. Most Point of Sale system track your COGS for you and in a lot of cases will even make the accounting entry for you. Otherwise the formula is Beginning inventory plus purchases minus ending inventory is your COGS and this is the number you should be using when analyzing your financials.