To assess your ability to:

  • Compute financial ratios.
  • Explain the steps used to make the computation.
  • Use illustrations from the chapter readings and the additional information for the business brief.
  • Prepare a simple Income Statement.

Action Items

  1. Review the Grading Rubric (below).
  2. Access your eTextbookand read Chapter 15.
  3. Read the following additional information for this assignment:

For a business that sells products, the wholesale cost of the product sold is known as cost of goods sold or the cost of sales.

This assignment will present four concepts that you need to know to understand cost of goods sold. The concepts are:

  1. Cost of goods sold
  2. Standard financial statement format
  3. How inventory fits into the equation
  4. Gross profit margin

Cost of goods sold

In the accounting world, there are three overall categories of expenses: cost of goods sold, operating expenses, and extraordinary expenses. This assignment deals with the first category, cost of goods sold. Cost of goods sold is the direct cost of the products and services your business sells. This includes the cost of labor and overhead to produce the goods and freight to obtain the goods. Cost of goods sold can be directly identified in the end product. For a mason, the cost of bricks and mortar is a direct cost. These costs are directly identifiable as a part of the product produced.

The cost of insurance, fuel, and maintenance for the trucks used to carry the bricks and mortar are indirect costs. While these costs are part of the product produced and are incurred in the process of generating revenues, they cannot be identified as belonging to a specific job or product. Indirect costs such as heat, light, power, and rent are also known as operating expenses or overhead.

Operating expenses are listed under expenses in the profit and loss report (income statement). Only the direct cost of the product is included in the calculation of cost of goods sold. The cost of goods sold varies directly with the volume of goods sold; each sale adds to cost of sales. Operating expenses, on the other hand, are relatively fixed. The business will pay the same amount of rent and utilities whether 10 items or 100 items are sold.

Understanding the standard financial statement

Cost of goods sold and operating expenses are shown in separate sections of the profit and loss report. First, the statement shows revenues, followed by cost of goods sold. Cost of goods sold is subtracted from revenues to produce gross profit. Expenses are then summarized, totaled, and subtracted from gross profit to calculate net income from operations. Finally, extraordinary items – such as the gain or loss on a sale of fixed assets – are added or subtracted from net operating income to yield net income. The standard format for an income statement is therefore as follows:

The term revenue refers to amounts generated from the sale of goods and services. Cost of goods sold is the direct cost of the items sold. Operating expenses refer to the ordinary and necessary costs – other than direct costs – of running the business. These distinctions are important not only in presenting information in a standard format but also in analyzing business profitability.

How inventory fits into the equation

Calculation of cost of goods sold involves another account, inventory. When goods are purchased for resale, the cost is not recognized immediately. When goods are purchased, an increase in the inventory asset is recorded on the balance sheet. The cost of a sale is not recognized or reported on the profit and loss report until the sale is concluded. Calculation of the cost of goods sold is therefore inextricably intertwined with inventory.

The formula for calculating cost of goods sold is a logical and straightforward one:

  • Beginning Inventory + Purchases = Goods Available for Sale
  • Goods Available for Sale – Ending Inventory = Cost of Goods Sold

Purchases of goods add to the balance in inventory, and each sale reduces the inventory. We don’t know the amount of the reduction – the cost of the goods sold – without specifically identifying the cost of each item as it is sold. You can calculate the cost of goods sold by taking a physical count of the ending inventory and subtracting the cost of the ending inventory from goods available for sale.

XYZ Company, with cost of sales 2% higher than ABC Company, makes a $365,000 profit. ABC Company, with a 2% lower cost of sales, generates an additional $70,000.00, an increase of 19% in net income. Because they pay close attention to their cost of sales, ABC Company has a higher gross profit margin and is substantially more profitable than XYZ Company.

Use the following information to completed the questions in Action Items 4 – 8.

Cost of goods purchased, cost of good sold, and income statement.

The following data are for Montgomery Retail Outlet Stores. The account balances (in thousands) are for 2014.

  1. Compute the Cost of Goods Sold. Explain the steps you used to make the computation. Use illustrations from the chapter readings and the additional information for the brief.
  2. Prepare the simple Income Statement, using the information shown above in the additional information for the brief.
  3. Compute the amount of merchandise inventory to be shown on the January 1, 2015, Balance Sheet. Explain the steps you used to make the computation. Use illustrations from the chapter readings and the additional information for the brief.
  4. Consider and review the 5-step critical-thinking decision-making matrix located in the MBA Toolbox in Critical Thinking Process and adapt it to this situation.
  5. Write a 1-page analysis according to the Business Brief Guidelines. Complete sentences must be used (bullets not acceptable). Your analysis must be written using a concise writing style. Your brief should incorporate all of the answers to the questions posed above.