Over the next few blog posts, we’re breaking down the income statement so you can understand how it works, see how it impacts your business, and find new opportunities to improve your business because of it. Last week we covered the Revenue section. We started that section with Gross Sales and finished it with Net Sales.
Now we’re looking at the second section of your income statement, Cost of Goods Sold (sometimes called “COGS”). Here, we’ll add up all the costs associated with creating your product or service, and then we’ll subtract it from the Net Sales amount you came away with in the previous section.
A business needs to consider all of the costs associated with making, shipping, and storing its products. This might include raw materials, packaging, warehousing, freight, and more. And, since businesses might have inventory in various stages of production, the inventory at the start and end of the period needs to be accounted for.
However, it’s not as easy as simply adding up a bunch of numbers. There are two different ways of calculating your costs of goods sold and we’re going to take a momentary detour to talk about a slightly more complicated aspect of your business that you need to know.
A Detour on Cash and Accrual
The numbers that are put in this Cost of Goods Sold section really depend on whether your business is cash-based or accrual-based. This will impact how your inventory is accounted for.
In a cash-based company, a transaction occurs when money leaves or enters the bank. Think of the cash as the measurement of the transaction actually taking place. In an accrual-based company, a transaction occurs when the transaction happens. Think of the buyer picking up the phone and placing an order.
Example: Imagine a company that orders a set of stools for their cafeteria and has terms where they pay for the stools a month later.
- In a cash-based company the transaction would occur when they paid for the stools. That is to say they would still have that expense and bill, but the expense would not show up on the Income Statement until they paid the actual bill.
- In an accrual-based company the transaction would occur when they ordered the stools: They would have an expense when the stools are received and a bill to pay at a later date that is sitting in their accounts payable.
It is best summarized like this: In an accrual-based company, you have an account called “accounts payable” and one called “accounts receivable” so expenses and income can occur without affecting your cash accounts (bank accounts), whereas in a cash-based company there are no A/P or A/R accounts and thus the expenses are only occurred once they are paid and affect the cash balance.
So, let’s put that into concept on the COGS. Let’s say your company makes and sells tables. In a cash-based company, the various costs of goods sold would hit your income statement when you paid cash for the wood, paint, nails etc. Whereas in an accrual-based company, the costs of goods sold would sit in an inventory account and would only hit your income statement when you actually SOLD the table.
Okay? Now that you have a basic understanding of the difference between cash and accrual, let’s continue…
Back to the Income Statement
Here’s a very simple example of a company that makes a basic table and is on accrual basis:
COST OF GOODS SOLD
Beginning inventory of materials: $100,000
(Explanation: Currently this company has $430,000 in inventory, which is an asset. Then they sold X number of tables in the month and it left them with only $120,000 worth of the materials in their asset account, so the ending inventory gets subtracted.)
Less Ending inventory: $120,000
(Explanation: That says that the inventory consumed is $310,000 and thus COGS. So you would…)
Subtract subtotal from Net Sales: $975,000
Gross Profit: $665,000
However, if it was a cash-based company, the cost of goods sold would be completely different. There would be no inventory and since you paid out $330,000 in the month that would be the cost of goods sold for the month. As well, the “beginning inventory of materials” would not have existed because it would have been written out in a previous month.
This section breaks out all of the costs associated with your products. It’s helpful to separate this number from other parts of your business for a few reasons: First, the opening and closing inventory and all of those related expenses are more easily calculated and reviewed when lumped together. Second, it gives you a truer picture of your business by breaking out these costs which are necessary to delivering your product.
Review these numbers carefully in your income statement and see if there are ways that you can negotiate lower costs with your suppliers.
This is part 2 of 4 parts of your income statement. Next week, we’ll look at the third part.