A Simple Way to Understand Cost of Goods Sold

One of the keys to your business viability is to understand your Cost of Goods Sold, but unfortunately this is one expense that most of our clients find very confusing.

Rent is an expense that you incur regardless if you sell anything or not. A Cost of Goods Sold expense is only generated by the sale of your product.

If you are a service-based business you will not incur this expense because generally you do not sell any products – you are just selling your service. But if you are a product-based business then you will always have a Cost of Goods Sold expense.

We will use the example of an ice cream shop to determine its monthly Cost of Goods Sold:

• The first thing to track is your sales – Perhaps this store sold $5,000.
• The next thing to track is the amount of purchases you made in that month of your product. Suppose this store purchased $3,000.
• The last thing is to count the inventory you have left in your stockroom at the end of the month. In this example let’s say we determined the value of ice cream to be $4,000. (Now you know the value of your closing inventory for this month and the opening inventory for next month.)

Now let’s put it altogether using this accounting formula to determine your Cost OF Goods Sold.

Opening Inventory + Purchases – Ending Inventory ÷ Sales = Cost of Goods Sold

OR

Let’s take this one step further to determine your Gross Profit for the ice cream.

Your Gross Profit is the amount of money your business has left to pay its expenses.

** If next month you determine your Costs of Goods Sold is $2,000, then your Gross Profit (based on the same amount of sales) will be $3,000. Now you will have less money to pay for your expenses.

This is why it is so important for you and your business to have a good bookkeeping system that is both manageable and up-to-date. You will have the figures available to make informed decisions as to: how to increase your sales or decrease your expenses.

So many small businesses do not know this number because they neglect to track their sales; they neglect to record their purchases; and they fail to complete ongoing and regular inventories on time and on a regular basis.