We mentioned previously how a trading business differs from a service business: whereas a service business provides a service, such as accounting, medical or repair work, a trading business trades in inventory (it buys goods at a low price and sells it at a higher price).
A trading business will also differ from a service business in terms of its income and expenses – i.e. the way a profit is made: whereas a service business renders services, a trading business makes sales.
The income statement for a trading business will thus look slightly different to the income statement of a service business (check out the lesson on the income statement to review what it looks like for a service business).
Here is the income statement for a trading business:
The first section of the income statement for a trading business describes the core activities of a trading business, i.e. the buying and selling:
Sales: Sales are the full income for the year for selling goods.
Cost of goods sold: This refers to the cost of all the goods that we sold this year. It is also known as cost of sales. Cost of goods sold is an expense charged against sales to work out a gross profit (see definition below). So, for example, we may have sold 100 units this year at $4 each, and these 100 units that we sold cost us $3 each originally. So our sales would be $400 and our cost of the goods we sold (cost of sales) would amount to $300. This would result in a gross profit of $100 (sales minus cost of sales). Cost of goods sold is not the same as purchases, as you will see from our examples below.
Gross profit: An initial profit on the product we are selling, before deducting general business expenses.
Example of a Trading Business Buying and Selling
Okay, let’s do an example where we can work out the sales, cost of sales and the gross profit for a business. Here's our example of Ms. Sheppard's business again:
Cindy Sheppard runs a sweet shop. She enters into the following transactions during July:
July 1 Purchases 1,200 sweets at $1 each. July 13 Purchases 500 sweets at $1.20 each. July 14 Sells 700 sweets at $2 each.
How many sweets does she have at the end of the month?
Answer: 1,200 + 500 – 700 = 1,000 sweets
Okay, let's calculate the value of her closing stock using each of the FIFO, LIFO and weighted average cost methods...
1. The First-In-First-Out Method (FIFO)
As you can see, even though the purchases amounted to $1,800, the cost of goods sold (or cost of sales) amounted to $700.
2. The Last-In-First-Out Method (LIFO)
In this case, even though our purchases amounted to $1,800, our cost of goods sold (or cost of sales) amounted to $800. This is calculated as follows: (500 X $1.20) + (200 X $1.00) = $800.
3. The Weighted Average Cost Method
Again our purchases are $1,800, but this time our cost of sales comes to $741.
So as you can clearly see, purchases and cost of goods sold, although related, are not the same thing.
Closing Inventory and the Cost of Goods Sold Formula
Now, let’s look at a summary of the figures we have calculated from these three methods:
We can work out some very useful formulas using these figures…
The closing inventories can always be calculated as follows:
If we switch around the equation to make cost of goods sold the subject, we have a formula for working this out:
Try these two formulas using the above table and you will see that they work every time.
For example, with the FIFO figures, we can see that we had 0 inventories to start with, plus we purchased $1,800 worth of goods. Of these $1,800, we sold $700, so we were left with $1,100 closing inventories. Using the same figures, we can see that we purchased $1,800 worth of goods and were left with $1,100, so we must have sold $700 worth of goods (the cost of goods that we sold).
The last formula above is actually well known - it is called the cost of goods sold formula or the cost of sales formula.
Almost every accounting student I have encountered has had to memorize this formula because they simply didn't understand what it means and how it works in practice. The explanations above should make it easier for you to understand and work with this key formula.
Once we have calculated our gross profit from the sales and cost of goods sold, we add other income to this and deduct general business expenses from this, to arrive at our net profit.