Each industry is different in determining costs of goods sold or cost of services rendered. Retail uses two distinct methods to calculate costs of goods sold. The first is called ‘Specific Identification’ whereby each item sold is specifically identified to its recorded cost. The second method is referred to as ‘Inventory Adjustment’ format. In this method, a beginning and ending balance is recorded along with the purchases throughout the year. There are many variations of this method when the price paid for the purchase of inventory varies throughout the accounting period. These variations include First In First Out (FIFO), Last In First Out (LIFO) and Average Costing.
The traditional format is to add purchases to the beginning inventory which equals total inventory available for sale, from this number is subtracted the ending inventory balance, the change during the accounting period equals that stock or inventory that left the store via sales. Remember, cost of goods sold is a negative number in the income (profit and loss) statement. Revenue is positive, cost of goods sold is negative; the result is hopefully a positive gross margin. However, it isn’t that simple. So the business owner needs to understand the definition and the variances that affect the final number we call ‘Cost of Goods Sold’. The following sections describe and illustrate the two common methods and the variations within each method.
Specific Identification Method
The specific identification method of calculating cost of goods sold is pretty straight forward. Use the actual cost of the item sold as the amount in Cost of Goods Sold. This method is very easy to use and implement in a low volume high cost per item retail format. Examples include dealerships (auto, RV, marine, equipment etc.), jewelry, computers, sporting goods, tires, electronics, appliances, furniture etc. Pretty much any retail item with a serial number is a good example of utilizing this method. There is no need to use the beginning or ending inventory values as the cost is specifically known for each respective item sold. Therefore; total sales less the actual cost of the items sold determines gross profit.
The owner of this type of business should use accounting software that can identify the specific item by model and serial number sold to accumulate the total cost of goods sold within the accounting period.
Inventory Adjustment Method
This method uses the beginning and ending inventory to determine the final actual cost of goods sold. Inventory adjustment method works well in high volume low cost retail operations. Examples include grocery stores, clothing outlets, flower shops, gift shops, auto parts, shoe stores, etc. The following formula is used to determine cost of goods sold:
Beginning Inventory $ZZ,ZZZ
Sub-Total Purchases ZZZ,ZZZ
Less Supplier Issues:
Discounts (Volume, Early Pay) (Z,ZZZ)
Returns & Allowances (Z,ZZZ)
Sub-Total Supplier Issues ( Z,ZZZ)
Equals Total Cost of Goods Available For Sale $ZZZ,ZZZ
Less Ending Inventory (ZZ,ZZZ)
Total Cost of Goods Sold $ZZZ,ZZZ
The ending inventory dollar value becomes the beginning inventory dollar value for the next accounting cycle. The key is that the inventory is valued at cost.
For smaller businesses, the above method is acceptable. However, in larger operations where several million dollars of high volume transactions occur (not high dollar cost transactions as illustrated in the specific item method), the owner may consider using some variation of the inventory adjustment method. The variations include:
FIFO – First In, First Out
This method assumes that the inventory is rotated through the warehouse to the sales floor, whereby the ending inventory value is calculated using the most recent price of the items purchased. In low inflation or minimal price fluctuations for the items sold, this method has very little impact on the final inventory cost valuation. If however, there is large price variation for the respected individual items between the beginning and the ending inventory, then this method better matches the cost of items sold to the revenue generated via the sales.
In general, this method is preferred because in almost all situations, inventory is rotated through the store, especially in groceries or some other time sensitive product for sale (flowers, animals, prepared foods, feed & seed, fad related items).
LIFO – Last In, First Out
This variation values the ending inventory at the beginning inventory dollar value. It is generally more conservative in nature as the ending inventory is worth more in value per unit due to inflation or market trends. This variation keeps the Cost of Goods Sold at a higher dollar value than the other variations.
In general, this method is rarely used for several reasons. It is a bit more complicated, over time, the inventory is woefully understated in value, and it can create misleading financial statements. Its only positive value is in relation to keeping the cost of goods sold dollar value high so profits are lower and this can benefit the owner for tax purposes.
Here the ending inventory is valued at the average cost to purchase the inventory during the accounting period in question. This is the most commonly used variation of the Inventory Adjustment Method for it better matches the overall cost of goods sold to the revenues generated. It works very well during low inflationary times and during periods of time where the products sold have little to no fluctuation in purchase costs. It does require some accounting prowess to successfully calculate the final inventory dollar value.
In principle this method works well and provides a reasonable final financial statement (income statement and balance sheet) and dollar value for the ending inventory.
As a small business owner of a retail environment, choose the method and then the best variation to determine the best optimum value for cost of goods sold. If you need any help or some input, contact me via the comments and I’ll give you my thoughts as to what I believe is your best method. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you.