Abe Sherman tells you how to unravel the mystery that is ?cost of goods sold.?
WHAT IS ?cost of goods sold?? In simple terms, it’s the actual cost of the merchandise you sold. It’s the flip side of gross profit and one of the basic things tracked by your point-of-sale system. An item you sold for $100 that has a cost of $45, has a COGS of $45 and a gross profit of $55. It’s those actual costs that should appear on your internal financial statements.
It sounds like the easiest thing in the world to measure and track, but before computers, accountants had to create a formula to measure it, and today many jewelers still arrive at COGS by using the formula.
Rather than relying on your POS system to provide an accurate report on exactly what the jewelry you sold cost you, accountants rely on the age old formula: Beginning Inventory + Purchases – Ending Inventory = COGS. We know why they did it that way before computers, but does this make sense today, given the tools we have at our disposal?
It is logical that if you started your year with an inventory of $100,000, purchased $80,000 throughout the year, and wound up with an ending inventory of $110,000, the cost of all of the merchandise you sold was $70,000 ($100 + $80 – $110 = $70). This is a down-and-dirty method for your financial statements perhaps; however, there are a couple of problems with relying on the formula. One is shrink, and the other is freight.
Using ending inventory as part of the formula, doesn’t take into consideration inventory shrink. If you have problems with merchandise not being accounted for when it’s sold, SKUs being assigned to the wrong items or ? worse ? internal theft, these important issues have to be corrected. At year’s end, if there is inventory missing, usually that would not be reflected in your financials.
Now, I understand that you wouldn’t want to share with your banker that you lose $30,000 worth of merchandise each year, but this information is for internal management purposes and should be tracked and corrected, while at the same time allowing you to accurately measure your COGS and gross profit margin. If you have faith in your POS system, start using its reports to state what your actual COGS are. If not, it’s time to find a new POS system.
Another issue I have is freight-in, which as a generally accepted accounting principle is often included in the cost of bringing in the item.
My issue with this is that the cost of bringing in merchandise is then hidden in the cost of goods sold. For example, every diamond you bring in on memo costs you money. Do you know how much? How is that trending over the past few years? Most jewelers don’t know.
Shipping fees are in the 1-2 percent range of total sales, which are not insignificant numbers. If you manage to incur expenses of 2 percent of sales in freight and lose another 1-2 percent to shrink, your gross profit will be understated by thousands of dollars.
The inclination is often to order yourself to ?Get your margins up!? and you may be inclined to raise your prices, when fixing these management problems would be far healthier for your business while keeping your prices competitive.
Relying on an antiquated profit-and-loss formula that ignores what should be line items in your management reports, could wind up costing you an awful lot of money. Carefully tracking some key performance indicators ?COGS, shrink, freight, etc. ? will go a long way to help you better understand and manage your business.