2. Cost of Sales Flashcards
Define cost of sales.
Cost of sales: Opening inventory + purchases + delivery inwards - closing inventory = cost of sales. This amount is then deducted from revenue to arise at the business’s gross profit.
Why is opening and closing inventory included in the statement of profit or loss?
Including the cost of inventory sold in the period in profit or loss is an application of accrual accounting.
What is the accounting treatment for unsold goods at the end of a reporting period?
Goods might be unsold at the end of a reporting period and so still be held in inventory.
Under the accruals concept, the cost of these goods should not be included in the cost of sales as they have not contributed to revenue generation.
Instead, the goods should be carried forward and matched against revenue in subsequent periods when they are sold.
What are delivery costs?
Who pays delivery costs?
Delivery costs refer to all costs of transporting purchased goods from the supplier to the customer.
One party has to pay for these delivery costs: sometimes the supplier pays (in which case the customer has no costs to record) and sometimes the customer pays.
What is the distinction between delivery inwards and delivery outwards?
When the supplier pays, the cost to the supplier is known as delivery outwards as the goods are going out of the business.
When the customer pays, the cost to the customer is known as the delivery inwards as the goods are coming into the business.
What is the accounting treatment for inward delivery costs and outward delivery costs?
The cost of delivery outwards is a distribution cost deducted from gross profit in the statement of profit or loss.
The cost of delivery inwards is added to the cost of purchases and is therefore included in the calculation of cost of sales and gross profit.
What is included in cost of sales for service organisations? (3)
- Direct labour costs - this is the cost of any labour services directly related to the service provided. If, for example, a graphic design company has been commissioned to create new branding for a business’s social media pages, the labour cost of the designer would be included, but the labour cost of the payroll manager of the graphic design company would not be included.
- Sales commission - if a business pays its employees a commission or bonus related to securing work, the cost of the commission paid should be included in the cost of sales.
- Materials used - some service organisations will have some material costs despite being service providers. For example, the graphic design company referenced above might incur printing costs in producing hard copies of the new branding or logos for presentation to the client.
Why may a business be unable to sell all the goods purchased before they can be sold? (3)
- Be lost or stolen
- Be damaged and become worthless
- Become obsolete or out of fashion; these might be thrown away, or sold off at a low price
What is the accounting treatment if a business still has good in inventory which are either worthless or worth less than their original cost? (2)
If, at the end of a reporting period, a business still has goods in inventory which are either worthless or worth less than their original cost, the value of the inventories should be written down to:
1. Nothing, if they are worthless; or
2. Their net realisable value, if this is less than their original cost.
A journal entry into the computerised accounting system will be required to account for the write down.
How does written down/written off inventory affect the gross profit of a business?
The cost of inventory written off or written down does not usually cause any problems in calculating the gross profit of a business, because the cost of sales already includes the cost of inventories written off or written down.
If included in gross profit, what would the affect if a material amount of inventory has been lost or stolen?
Where a material amount of inventory has been stolen or destroyed, including its cost in gross profit will give a very distorted idea of the business’s basic profitability:
- Purchases will include the cost of goods that could not be sold, so the accrual principle is broken, yet they are not in closing inventory either so it will look as if the business’s gross margin on sales has fallen catastrophically.
- There may be an amount of income as a result of an insurance claim, which cannot be included in the cost of sales under the ‘no offsetting’ principle.
