Bookkeeping – Debits and Credits in Cost of Sales Accounts (Lesson 7)
Cost of sales customarily carries debit entries in the ledger.
The Purchases Journal keeps track of the entries related to the cost of sales (cost of goods sold) accounts. As with all journals, the entries are in chronological order by date and identify both the debit and credit sides of the equation. In this case, cost of sales is customarily recorded via debits. The offsetting credit is usually to either the cash account for those materials directly purchased from a supplier or on an account of a supplier. For those on account from a supplier the entry is to Accounts Payable. Just like entries via the sales journal and on account to customers, there are subsidiary ledgers by vendor for purchases on accounts.
Cost of Sales – Gross Profit
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.
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 – Different Names
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.
For the purposes of this lesson, the more generic title ‘Cost of Sales’ is used.
Cost of Sales – Various Accounts
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 sub-accounts. 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 in them. This is wrong. Remember, every type of 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). Credits do exist in Cost of Sales but are more complicated and uncommon. This is covered in the advanced lessons of bookkeeping, Volume II and III. For now, you need to understand that debits can exist in Cost of Sales accounts.
Summary – 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. With 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.
Do you want to learn how to get returns like this?
Then learn about Value Investing. Value investing in the simplest of terms means to buy low and sell high. Value investing is defined as a systematic process of buying high quality stock at an undervalued market price quantified by intrinsic value and justified via financial analysis; then selling the stock in a timely manner upon market price recovery.
There are four key principles used with value investing. Each is required. They are:
- Risk Reduction – Buy only high quality stocks;
- Intrinsic Value – The underlying assets and operations are of good quality and performance;
- Financial Analysis – Use core financial information, business ratios and key performance indicators to create a high level of confidence that recovery is just a matter of time;
- Patience – Allow time to work for the investor.
If you are interested in learning more, go to the Membership Program page under Value Investing section in the header above.
Join the value investing club and learn about value investing and how you can easily acquire similar results with your investment fund. Upon joining, you’ll receive the book Value Investing with Business Ratios, a reference guide used with all the decision models you build. Each member goes through three distinct phases:
- Education – Introduction to value investing along with terminology used are explained. Key principles of value investing are covered via a series of lessons and tutorials.
- Development – Members are taught how pools of investments are developed by first learning about financial metrics and how to read financial statements. The member then uses existing models to grasp the core understanding of developing buy/sell triggers for high quality stocks.
- Sophistication – Most members reach this phase of understanding after about six months. Many members create their own pools of investments and share with others their knowledge. Members are introduced to more sophisticated types of investments and how to use them to reduce risk and improve, via leverage, overall returns for their value investment pools.
Each week, you receive an e-mail with a full update on the pools. Follow along as the Investment Fund grows. Start investing with confidence from what you learn. Create your own fund and over time, accumulate wealth. Joining entitles you to the following:
- Lessons about value investing and the principles involved;
- Free webinars from the author following up the lessons;
- Charts, graphs, tutorials, templates and resources to use when you create your own pool;
- Access to existing pools and their respective data models along with buy/sell triggers;
- Follow along with the investment fund and its weekly updates;
- White papers addressing financial principles and proper interpretation methods; AND
- Some simple good advice.