General accounting
VII. 30. Alternate way to compute the COGS and to prepare the IS
Video
So far, we studied the traditional way to compute the COGS and prepare the top part of the Income Statement.
In this lesson, we study an alternative, more modern, way.
The two ways are absolutely equivalent as far as the value measurements and year-end documents are concerned.
Here is a typical Income Statement with the top part (called the "Trading account") in its traditional form.
The COGS are implicitly computed with the lay-out of Opening stocks, Purchases, and Closing stocks.
The formula is
COGS = Purchases - [ Closing stocks - Opening stocks ]
In the example, it yields COGS = 6000 - [ 3500 - 2500 ] = 6000 - 1000 = 5000€.
And the Gross profit (also called Gross margin) is Sales - COGS = 12 000 - 5000 = 7000€.
The opening stocks (of the accounting cycle) is simply the closing stocks of the previous cycle. So here, we are not in the first year of existence of the firm.
Then, in traditonal accounting, we record all along the cycle the Purchases, without worrying about what we sell or not.
Then we make a final inventory, and compute the value to us of what we actually sold.
The COGS, as the name says, is the cost of the goods actually sold. It is necessarily the Purchases minus any increase in inventory, or plus any decrease in inventory.
Remember the special character of the Sales account.
Here is the naive representation of a sale: some goods leave the firm, and some value (cash, cheque, or IOU) enters the firm.
But, in a sale transaction, we cannot just debit the cash account (or whatever other account which receives the payment) and credit inventory of goods, because the two legs are unequal. They have different values.
Indeed a sale is the fundamental operation via which the firm generates profit.
So the merchants who invented accounting eight centuries ago created this special account named "Sales", which, in a sale transaction, is credited.
And, at the end of the year, we compute the value, in debit, of the goods sold.
Then the calculation of the Gross margin is handy: it is Sales - COGS.
And when we subtract the other expenditures of the year (to produce these sales), we reach the Net Result of the year, that is the bottom line of the Income Statement.
The computation of the COGS leads also neatly to a new value of stocks at the end of the cycle in the Balance Sheet.
We studied this: it is done through the adjustment for inventory, where, with the value of the ending inventory,
- we credit a "closing stock IS" account, and
- we debit a "closing stock BS" account.
To be as clear as possible, let's follow the traditional procedure, with items bought and sold.
Suppose the shop buys clothes (all the same) 50€ apiece, and sells them at 120€ apiece.
And suppose our opening stock is made of 50 items (value for us = 2500€).
During the year, we purchase 120 items. Therefore the balance of the Purchases account, at the end of the year, will be 6000€.
And we sell, during the year, 100 items. At the end of the cycle, the balance of the Sales account is 12 000€. And this amount of value flowed into the firm (in the form of cash, cheques and IOU, if we grant credit to some customers).
Finally the closing stock will necessarily be 70 items (50 at the beginning + 120 purchased - 100 sold), the value of which, to us, is 3500€.
The cost of the 100 items sold is 50€ x 100 = 5000€. It is nicely computed with COGS = Purchases - Δ Stock.
This calculation is implicitely made in the Trading account (= top part of the IS).
So, what is the alternative way to record COGS?
Well, we shall have no more "Purchases account". We shall have only one "Stock account", and we shall have a "COGS account" all along the cycle.
Whenever we buy a garment
- we debit the "Stock account" 50€
- we credit whichever account we pay with, the same value
And whenever we sell a garment, the recording is slightly more involved since we take care of two transactions:
- record of sale
- we debit whichever account receives the payment of 120€ by the customer
- we credit, as usual, the special "Sales account" 120€
- record concerning the goods
- we credit the "Stock account" 50€
- we debit the "COGS account" 50€
At the end of the accounting cycle, not only do we have of course the sales figure, but also
- the COGS are already computed
- the stock account is ready too
In this alternative, more modern, way there is no more Purchases, no more adjustments for inventory at the end of the cycle.
The final inventory (which is legally required) is just a check.
Of course if there is a discrepancy, this means some goods were lost or stolen, or perhaps on the other hand appeared magically in the stock.
Every morning, I buy my newspaper at the newsstand down the street from my home.
The clerk always asks me to hand her the paper to pass it in front of a laser barcode scanner. Doing so she triggers several real time accounting records: the stock of newspapers is credited the value she paid for the paper, the COGS is debited the same value; and at the same time the Sales are credited my payment, and the till is debited the money I give her.
