Learning more about Cost of Sales (Cost of Goods Sold)

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This section of the profit and loss account covers the trading activities of the business, meaning whatever the business is selling to other businesses. Therefore this section contains sales, less the cost of any goods sold. This produces the gross profit.
        Example                                     No. of                                   P & L
                                                           Articles                                £         £
 
         Sales                                                     15                                        150
        Opening Stock                          13                                        30
        Add: Purchases                        10                                      100
                                                          23                                      130
        Less: Closing Stock                ( 8)                                      (50)
        Therefore Goods Sold                           (15)                                    ( 80 )
        Gross Profit                                             0                                         70
                                                                       ==                                         ==
As far as the accountant is concerned, the column showing the number of articles is not available. This is merely included here to show you how the figures have been derived. By excluding the number of articles, the line which shows 'Goods sold' becomes 'cost of goods sold, because only £'s value is used and not the number of items sold.
 

ACTIVITY
Keith purchased 10 calculators which he intends to sell for a profit. The calculations cost Keith £2 each, and therefore his purchases have cost £20 [10 x 2].
During the next month, Keith sells 6 of the calculators for £5 each, giving him a total sales figure of £30. Calculate: Keith's profit for the month.
Will this figure represent Gross Profit, or Net Profit?
 

ANSWER:                                                              £
Sales(6x£5)                                                           30
Less cost of sales:
    Purchases                                     20
    Closing stock                               (8)               (12)
    Gross Profit                                                      18
 

    The profit shown is Gross profit.
    Closing stock is calculated from 4 calculators at £2 each [ie 4x £2]

In order to arrive at Gross Profit we need to deduct from the sales earned during the accounting period, the cost of items sold. This is known as the cost of goods sold. The prime books of entry and the legal framework which governs the accounting treatment and recording of sales and purchases are such that it is not possible to ascertain the cost of goods directly from the normal accounting records. These records will give us the sales and purchases made for the year. However, the purchases made for the year will only equal cost of sales, if none of these purchases are left in the stores [unsold] at the end of the year. Equally if there already existed stocks in the stores at the beginning of the year, we need to take these into account. The stocks which exist at the beginning of the year are known as opening stock. Stocks existing at the end of the year are referred to as closing stocks. Perhaps a little illustration will be helpful at this point.

Let us assume that I have just commenced trading and in my first year I have sold two woolley hats for £10 each. The hats cost me £5 each. My trading account will look like this:
                                                              £
    Sales [2 x £10]                                 20
    Less cost of sales [2 x £5]             (10)
    Gross Profit                                     10

I know the cost of the 2 items sold. However, let us now assume I have sold thousands of items of different sizes and colours all costing me a different price depending where and when I have purchased them. In addition, let us assume that I have sold these very different types of hats for quite different sales prices. My accounting system will record, for the year, the total sales value made. It will also record total purchases made. It will NOT, however, tell me what is left to be sold at the end of the year. [The cost of this is known as closing stock]. Neither will it tell me what was already in the stores at the beginning of the year, [my opening stock]. The only way I can calculate cost of goods sold is by taking total purchases for the year and deducting the cost of stocks left yet to be sold at the end of the year [closing stocks] and adding the stocks which existed already at the beginning of the year [opening stocks]. The value of closing stock for one accounting period serves as the value of opening stock for the following accounting period.


                                                                                                                       
1.1.98                                         31.12.98     1.1.99                                              31.12.99

Closing stock for 31.12.98 equals opening stock for 1.1.99. The way we calculate closing stock is by COUNTING and valuing stocks existing in stores at the end of the year. This process is known as the stock taking process. The value agreed on closing stock has a direct effect on the gross profit. If closing stock is accidentally overstated by £10,000 then the gross profit is equally overstated by £10,000. It is for this reason that observation of stock taking procedures is undertaken by the external auditors in order to ensure accuracy of recording of closing stocks.
A simple example of cost of goods sold follows:
At the beginning of the year we have one hat in stores . Therefore Opening Stock = 1 hat
During the year I purchased 4 hats. Opening stock and Purchases now = 1 + 4 = 5
During the year I sold 2 hats.
At the end of the year stock left is counted and found to be 3 hats. Closing Stock is therefore the purchase price of 3 hats.
Cost of goods sold = Cost of:-
Opening stock                                             1 hat
Plus Purchases                                         + 4 hats
        [What I purchased during the year]
Less: Closing stock                                  - 3 hats
        [what's left at the year end].                2 hats

Number of items sold  were 2 hats . If each hat costs £5 then the value of cost of goods sold is 2 x £5 = £10.

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