How is Cost of Goods Sold in Retail Determined?


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. 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
Plus Purchases:
    Purchases                                        ZZ,ZZZ
    Shipping                                          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.

Average Costing

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

Value Investing

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:

  1. Risk Reduction – Buy only high quality stocks;
  2. Intrinsic Value – The underlying assets and operations are of good quality and performance;
  3. 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;
  4. 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:

  1. 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.
  2. 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.
  3. 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.

Value Investment Club

Please Signup
*
Username
Username can not be left blank.
Please enter valid data.
This username is already registered, please choose another one.
This username is invalid. Please enter a valid username.
*
First Name
First Name can not be left blank.
Please enter valid data.
This first name is invalid. Please enter a valid first name.
*
Last Name
Last Name can not be left blank.
Please enter valid data.
This last name is invalid. Please enter a valid last name.
Website (URL)
Website (URL) can not be left blank.
Invalid URL
Invalid URL
*
Email Address
Email Address can not be left blank.
Please enter valid email address.
Please enter valid email address.
This email is already registered, please choose another one.
*
Password
Password can not be left blank.
Please enter valid data.
Please enter at least 6 characters.
    Strength: Very Weak
    Select Your Payment Gateway
    How you want to pay?
    Payment Summary

    Your currently selected plan : , Plan Amount :
    , Final Payable Amount:
    Submit
    Please follow and like us: