The Inventory-Cost Connection: Figure Out Cost of Goods Sold
In order to ﬁgure out your proﬁt or loss for a period, you need to know several key ﬁgures. One of the most crucial is the cost of goods sold; with that number, you can calculate your gross proﬁt and begin to get down to the bottom line. Unlike other numbers (such as total sales or postage expense), the total amount of cost of goods sold can’t just be plucked from a ledger account. Instead, it has to be ﬁgured out based on activity in the inventory accounts.
With accounting software, you may be able to get an automatic, preliminary cost of goods sold with a click of your mouse. That number will need to be adjusted based on your ending inventory numbers, but it can give you a good idea of where the final figures will fall.
To get to your true cost of goods sold, you need to know the exact amount of inventory on hand at the end of the accounting period; that’s your ending inventory. The only way to get that number is to take a physical inventory—that’s right, you have to count every piece of inventory you have. That number may come pretty close to your book inventory, if you use a perpetual inventory system, but it won’t be exactly the same.
That ending inventory is just one part of the cost of goods sold equation, albeit a very important part. To get to your cost of goods sold, you also need to know your beginning inventory (which will equal the prior period’s ending inventory) and your total purchases for the period. The combination of beginning inventory and purchases gives you a subtotal called “merchandise available for sale,” which is basically everything you could have sold during the period. From that subtotal you subtract your ending inventory, which represents what you have left on hand. The result there lets you know how much was sold during the period—your cost of goods sold.
Taking the Inventory
At least once a year, as part of your accounting tasks, you have to count, weigh, or measure every piece of inventory that your company has on hand. On that day (or those days, depending on how much inventory you have), putting a hold on everything else will make this not-much-fun task ﬂow more smoothly. That means don’t buy anything or sell anything until you’re done taking the inventory. This will make your inventory-taking task much easier and more accurate.
Get yourself a big, fat notebook. Designate at least one page for every separate item of inventory you have. Then start counting and writing. Only include salable items in your total count; if you don’t think you can sell it, it shouldn’t be counted as viable inventory.
When you come across a box that is supposed to contain one or more items, open it to see what’s inside. That may sound like overkill, especially if you have been the only one handling the merchandise, but it’s still a good idea. For one thing, if the box hasn’t ever been opened, you have no way of knowing whether the item is in one piece, or even whether it’s the right item. If the box has been opened, it may now contain fewer items than it started out with (you can’t expect to remember every time you took something out of a box), or something could have broken since the last time you looked.
Then there’s mold, water damage, freezing, overheating—probably dozens of things that could impact the state of your inventory. Add employees to the mix, and you open up the possibility of inventory walking out the door. Granted, you probably hire only employees whom you trust not to sneak out with a wide-screen TV. However, even the most trustworthy employees may not think twice about grabbing a six-pack of soda from the back, or taking home some blank CDs.
The point is, unless you take the time to go through your inventory and count every piece, you won’t truly know what you have on hand. To get an accurate picture, you need a physical count. That accuracy will ﬂow through to your statement of proﬁt and loss to give you your bona ﬁde bottom line.
Cost of Goods Sold for Manufacturers
Manufacturing companies have an extra twist added into their cost of goods equations. Although there’s a lot of different inventory here, only ﬁnished goods ever make it into the hands of customers. To get to your cost of goods available for sale (those total ﬁnished goods), you ﬁrst need to know how much was made—that’s called the cost of goods manufactured.
For manufacturers, cost of goods manufactured plays the same part that purchases do for retailers. That number tells them the dollar amount of finished goods that were added into inventory during the period, just as if they had purchased the products already complete.
To get to the cost of goods manufactured, you start with your work in process inventory from the beginning of the period. Add to that the current manufacturing costs: all the direct material, direct labor, and manufacturing overhead from this period. That gives you the total costs associated with work in process. Now deduct your ending work in process inventory. The ﬁnal result here gives you the total cost of goods manufactured during the period, also known as the total ﬁnished goods you’ve added to that branch of your inventory.
To get to your costs of goods sold, start with the ﬁnished goods inventory from the beginning of the period. Add your cost of goods manufactured to that to get your total goods available for sale. From that subtotal, subtract your ending inventory number for ﬁnished goods. The bottom-line grand total gives you the cost of goods sold.