A very common mistake in bookkeeping is the misunderstanding of the function of the cost of sales accounts. In almost every industry financial comparisons are made between similar operations to evaluate performance. The most common ratio or evaluation tool is the ‘Gross Profit Percentage’. Gross profit refers to the value of revenue remaining after subtracting cost of sales. The gross profit percentage is merely the dollar gross profit value divided by the net revenue value.
This ratio or percentage is quantifiable different for every industry. For example, in the service industry the gross profit should not be less than 40%. This means the cost of services rendered is around 60% of all net revenue.
In auto repair, the gross profit percentage is generally higher sometimes hitting 55%. For some industries, it is not uncommon for the gross profit percentage to be as low as 15%. A good example of this is the automotive retail business. The gross margin generated from each auto sold is relatively low. By the time the dealership pays for the car, pays the commission to the sales representative, pays the interest on the floor plan and more, the gross profit drops to a very low percentage of net revenue.
So the purpose of the cost of sales accounts is to group together those direct costs related to the product or service sold to the customer. Then it is easier to compare the overall performance of your business to others in a similar business.
Cost of sales has several different names. The most common title is of course – Cost of Goods Sold. This is the title almost everybody has heard of in business. It is used in the retail industry but other industries used different titles to refer to the same concept. The following are some examples:
- Costs of Construction – residential, commercial and industrial construction
- Cost of Meals Served – restaurants, caterers, mobile vending
- Cost of Departmental Operations – hospitality industry specifically hotels and resorts
If you desire to gain a more thorough understanding than read: Cost of Sales – Various Formats.
So for the purposes of this article I stick to the more generic title ‘Cost of Sales’.
The customary value for cost of sales accounts is a debit value. If the value were credit based it would increase the overall profitability of the business operation just as sales are credit based (see Lesson 6). For those of you new to accounting, cost of sales accounts can have several different subaccounts. The most commonly used subaccount is material or purchases. When you think of purchases think of buying some retail widget and then reselling this widget for a profit. This is why the ‘Purchases Journal’ is the preferred journal for posting cost of sales entries.
Other accounts include the following and their corresponding journal:
- Labor – payroll journal
- Shipping – shipping journal
- Subcontractors – most often kept in the purchases journal or a separate journal is used
- Equipment Rental – purchases journal
- Other/Supplies – purchases journal
A very common mistake made by novice bookkeepers is thinking that Cost of Sales accounts never have credit values entered into them. This is wrong. Remember, every type of an account can have either a debit or credit entered. Each type of account ends with a more common side of the entry (debit or credit). For example Asset types of accounts should end with debit values; Liability accounts customarily end with credit values. For Cost of Sales, debit values are normal.
Credit entries in Cost of Sales accounts usually occur as a function of customers returning an item. When this happens, the entry starts out in the sales journal with a debit to ‘Returns’ and a credit to the cash handed back to the customer. At the same time, the material return is recorded via an inventory journal or a returns journal with a credit to the purchases account for the returned item and a debit to inventory (an asset type of an account). So debits do exist in Cost of Sales but are more complicated and uncommon. I cover this type of transaction in the advanced sections of bookkeeping on this website. For now, you need to understand that debits can exist in Cost of Sales accounts.
Debits and Credits are merely values assigned to accounts and offset each other in order for the dual entry system to work effectively. In Cost of Sales type of accounts debit balances are the traditional ending balance. Debit entries do exist but are rare. In cost of sales types of accounts debits increase the balance and credits decrease the net cost of sales. Act on Knowledge.
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