Calculation of Cost of Sales
Calculation of Cost of Sales / Recording of Inventory on Hand
There are two methods of calculating your cost of sales:
- The Periodic method (Accounting refers to this as the Purchases method)
- The Perpetual method (Accounting refers to this as the Sales method)
The Periodic/Purchases method calculates your cost of sales by simply taking the total of all your inventory/item purchases and reflecting it on your Profit and Loss report (as Purchases). Any effect of either closing or opening inventory is ignored.
The Perpetual/Sales method calculates your cost of sales by including only the cost of items sold to your customers through your invoices.
- You purchased 10 widgets at $ 100 each giving a total of $ 1,000.
- You sold 4 of them.
The Periodic/Purchases method would reflect your cost of sales as $ 1,000.
The Perpetual/Sales method would reflect your cost of sales as $ 400 (4 x $ 100).
So the Periodic method would show $ 600 less profit than the Perpetual method.
To match the two, you would add back your closing stock which in this example would be $ 600 (6 units of $ 100 each i.e. you bought 10 and sold 4 leaving 6 units on hand). The situation is further complicated when you bring your opening stock to account.
Its for this reason that Accounting “keeps it simple” by using the Periodic/Purchases method as its default method to calculate your cost of sales (even though we give you the option when generating your Profit and Loss report to select the Perpetual/Sales method).
The Periodic method more closely reflects your cash flow (because purchases need to be paid for irrespective of whether or not you sold the stock). Its also easier to understand! A Balance Sheet however needs to reflect all your assets and liabilities.
Your stock (inventory) on hand at the close of a reporting period is indeed considered an asset.
Because Accounting uses the periodic method by default, you need to account for your Inventory on Hand at the end of your financial period by processing a journal entry. This journal entry should be processed either at the end of each financial year or at the end of each month – depending on your reporting requirements. For most people, the end of financial year is good enough.
Recording Inventory on Hand
We will show you how to process the correct journal to bring your closing stock onto the Balance Sheet so your current assets section looks like the example below.
In this example, we have assumed your Balance Sheet is run at 30 June (your financial year end):
For clarity, the inventory values above are grouped under the heading Inventory on Hand, using a Reporting Group in Accounting.
How to reflect your Inventory closing balance on the Balance Sheet
- Step 1 – Set up the correct accounts in Accounting
- Step 2 – Calculate your Inventory Value movements (difference between your opening and closing inventory)
- Step 3 – Process your Inventory Journal to reflect the above mentioned movement
Step 1 – Create the following Inventory Accounts
In order to process your journal entry you will need to set up some inventory accounts (if they don’t already exist).
Go to Accounts…List of Accounts…Add an Account and add the following accounts in Accounting. Note the financial categories illustrated below. These categories are used by Accounting to position the amounts in the right section of the Balance Sheet).
|Inventory Movement – Asset||Current Assets|
|Inventory Movement – Cost of Sales||Cost of Sales|
Step 2 – Calculate the Inventory Value
Assume you began using Accounting at the beginning of the current year.
You would’ve created your inventory items with their related opening balances – both quantity and value.
Accounting automatically puts this balance in a System Account called Inventory Opening Balance on the Balance sheet. In our example we will assume an opening balance total of $ 10,000.
Now assume that at the end of the year, your total inventory on hand (closing stock) amounts to $ 75,000.
You can get this total from your Item Valuation Report.
Good practice says you should conduct a stock take to check your item quantities on hand as reflected on the Item valuation Report. You should also check that the average cost value for each stock item is reasonable (in case mistakes have been made).
In our example, opening inventory totaled $ 10,000 and closing inventory totaled $ 75,000 reflecting an Inventory Movement of $ 65,000. This value is the difference between the Inventory Opening Balance and the Inventory Value (the Inventory Closing Balance). This is the amount that you will use to process your journal entry.
|Inventory Opening Balance: This amount will appear on your financial statements by default.||10,000|
|Inventory Value: Your actual inventory on hand value.||75,000|
|Inventory Movement: This amount needs to be recorded.||65,000|
Step 3 – Process the Inventory Journal Entry
Consult your accountant before processing these journal entries if you are unsure.
The journal entry will be processed to record the Inventory Movement to create the “inventory on hand balance” as at 30 June as follows:
On 30 June debit Inventory Movement – Asset with an amount of $ 65,000 by affecting the Inventory Movement – Cost of Sales account.
To process the journal go to Accountant’s Area…Process Journal Entries.
If when you are processing this journal and your closing inventory value is less than your opening inventory value, reverse the debits and credits on the journal entry.
The screen shot below shows this journal entry for the example above: