Sales, Cost of Goods Sold and Gross Profit

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 that of a service business:

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. Cost of goods sold 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.

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)

2. The Last-In-First-Out Method (LIFO)

3. The Weighted Average Cost Method

So as you can clearly see, purchases and cost of goods sold, although related, are not the same thing.



Now, let’s look at a summary of the figures we have calculated from these three methods:

The closing inventories can always be calculated as follows:

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 (with the cost of goods sold as the subject) 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.

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