Many small businesses operate without an inventory control system. When they buy goods for sale they post the cost directly to the Profit and Loss account under the title “purchases”. In this case the Gross Profit on the sale is calculated as:
Gross Profit = Sales – Purchases
What is wrong with this?
Most businesses that are “in control” review their performance every month.
If the goods that were purchased during the month were all sold in that month, the simple calculation above is quite ok.
However, if some of the goods are left over at the end of the month, then the calculation is saying that your gross margin is less than it should be. Actually what you want to know is “what profit did I make on the goods that I sold this month?”
In the old days when we didn’t have computers, the way the cost of sales were calculated is as follows:
Lets assume that we are starting with no inventory or stock or we go into the store and count what is there. At the beginning of the month a shipment arrives and “purchases” or the cost of inventory is recorded in the Balance Sheet as inventory received. It is not recorded in the Profit and Loss account because it has not been sold yet. It is an asset. Inventory.
Some of the stock is sold during the month. In a manual system someone goes into the store and counts the stock left at the end of the month. There may have been more shipments (purchases) during the month – it does not matter. The difference between the inventory at the beginning of the month and that at the end of the month plus the purchases must be what was sold.
Now we need to find out what profit was made on the goods sold during the month.
Cost of Sales = Opening Stock + Purchases – Closing Stock
and the profit is:
Gross Profit = Sales – Cost of Sales
Of course the business may have a system in the store room to record what goes in and what goes out so that the inventory on hand can be known at the end of the month.
If you have a computer based inventory control system in place the cost of each stock item is recorded when it arrives into store. Often the cost is known and recorded when the goods are ordered. This is an even better idea as then there is a check that the cost of goods received as per the suppliers invoice matches with the cost as per the purchase order. This is a good check that costs are not creeping up when management is not looking.
With an inventory control system, the cost of the stock not sold is known at all times thanks to the inventory robot that meticulously keeps the records.
Now each time a sale is made, the items sold are taken out of inventory. In the accounting system, the sale is recorded as normal and another separate entry is made, mostly automatically, to remove the cost of the items sold from the inventory.
The Gross Profit in this case is known on each an every sale.
Once this system is in place, an all important measure – inventory turnover – can be monitored. This is a great help in determining how much inventory to buy and how much should be kept in stock. Remember that inventory sitting in your store room is costing you money and valuable cash flow. The faster the turnover the better provided that you can supply customers without delay.