Accounting For You
|Posted on 22 April, 2014 at 8:12|
A potentially big mistake that can be made by small businesses is in thinking that the total cost of the purchases of materials etc. that they have made through the year becomes their “cost of sales” figure for the year. This is wrong!
Cost of Purchasing Materials for the year DOES NOT EQUAL Cost of Sales for the year!
Every purchase of materials that you make is actually a cost against your inventory or stock.
Any handmade business, or indeed any small business that makes its own product, will have two different inventories, one will be for raw materials, and one will be for finished products. Every time you purchase some raw materials you are increasing the size of your raw material inventory. Then, as you use some of those materials to make a product, so the raw material inventory will decrease and the finished goods inventory will increase. Equally, when you sell a product, so the finished goods inventory will decrease.
So, to give an example:
This of course is just a very simple example of the movements between inventory values when buying materials, making products and selling products.
With regard to the Finished Product stock, this can be costed as either cost price or selling price. Personally I recommend that for accounting purposes that your product inventory is costed at materials cost (plus labour costs if required). For my own jewellery inventory I have two columns, one for materials cost and one for sales value. I therefore have the materials costing of the inventory for my accounts but still know what the sales value of the inventory is.
It is very important to understand inventories because inventory balances and movements are used to calculate the cost of sales for the year.
Cost of Sales
Cost of sales can be determined in two ways: The best (and probably easiest way) to do this is via the inventory balances. The simple calculations is as follows:
So, to use the figures from the inventory example above:
Giving such simple examples you will see quite easily what the second way of determining the Cost of Sales is – quite simply it is the cost of the product that has been sold (as shown in red).
Now this may seem the easier option when presented with such a simple example, but when there is a lot of product that has been sold during the year, using the balances as shown above becomes the easier option to use.
Of course in reality inventories will be much more detailed than the examples shown above as each material should be listed with descriptions of materials, cost per item, quantities, total cost for items etc., as should each completed product.
So to summarise:
Cost of Sales for the Year = Cost of making the Products Sold in the Year.