and Gross Profit

**Previous lesson:** The FIFO Method & Weighted Average Cost **Next lesson:** Perpetual and Periodic Inventory

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.

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...

As you can see, even though the purchases amounted to $1,800, the cost of goods sold (or cost of sales) amounted to $700.

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.

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.

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.

Return to **What is Inventory?**

Return to the **Home Page**

**Previous lesson:** The FIFO Method & Weighted Average Cost **Next lesson:** Perpetual and Periodic Inventory

Help Support it with a Donation

*OR...*

Click below to see questions and exercises on this same topic from other visitors to this page... (if there is no published solution to the question/exercise, then try and solve it yourself)

**General Journal Closing for Sales**

When doing a general journal closing I am supposed to start with sales. Do I subtract sales returns and allowances and discounts in order to close revenue …

**Gross Profit Quick Question**

Q: If net revenue equals $50,000, cost of sales $20,000 and operating expenses $10,000, then what does the gross profit come to?
A: This question …

**Cost of Sales Formula?**

What is the cost of sales formula?
A: The cost of sales formula is:
Please see the lesson on Sales, Cost of Goods Sold and Gross Profit …

**Break Even Analysis**

Please help me with the following break even analysis question:
Particulars Shoes Socks
Selling Price 645.00 36.00
Variable Cost 516.00 27.00
Fixed …

**Cost Price, Sales Price, Mark-Up**

Q: How do you find the cost price if the sales are $216,000 and the mark-up is 50%?
A: "Mark-up" literally means the amount you "mark up" the cost …

**Cost of Goods Sold andInterest Expense**

(Please note that in the following question R = Rands, which is the South African currency) a) Sales totaled R15,000,000 b) Cash R370,000 c) Marketable …

**Multi-Step Income Statement**

Q: I have racked my brain on this and I cannot come up with an answer. If there were a business that did not have a cost of goods figure, would they still …

**Accounting Entry for Giving Away a Free Sample**

Q: What entry will be passed in the general journal for goods taken as a free sample?
A: The first thing to work out here is whether free samples …

**Cost Accounting - Fixed vs Variable?**

Q: Fixed costs are really variable, the more you produce the less they become. Do you agree? Explain?
A: Thanks for your questions Ujala.
I agree …

**Calculate Gross Sales Question**

(Rs = Rupees = Indian currency)
Opening stock Rs.30000,
Closing stock Rs.40000,
Purchases Rs.560000,
Returns outward Rs.15000,
Returns inward Rs.20000, …

**Gross Profit Question**

Q: How do you calculate the gross profit when you are given gross profit percentage?

**Income Balancing Amount Question**

Q: You are given the following figures:
- Beginning capital of 200,000 - Ending capital of 190,000 - Additional investment 30,000 and - Personal withdrawal …

**Gross Profit/Loss Question and Solution:**

Q: The following information is provided to you (note that Rs = Rupees, official currency of Pakistan, India and Sri Lanka. O/B = Opening Balance):
…

**Value of Closing Stock Question**

Q: Opening stock 80,000, purchases 160,000, sales 200,000. Gross profit 33%. Goods destroyed by fire 30,000. Received claim of 20,000.
What is the …

**Why Show the Highest Cost of Goods Sold Amount?**

Q: Why would someone want to show the highest cost of goods sold amount?
A: For tax purposes.
An intelligent businessman wants to claim the greatest …

**Purchases, Cost of sales, Control accounts**

**Search this website:**

**All the lessons on this site and much, much more...**

**Available ****Now On**

Make a Donation

Find schools and get information on the program that’s right for you.

Powered by

Subscribe to*The Student Accountant *newsletter

## Comments

Have your say about what you just read! Leave me a comment in the box below.