COST OF SALES 181
3 An operating account. Finally, gross profit might be carried forward to a third
account, the operating account, and adjusted for the other incomes and costs to
arrive at net profit (or loss). These other items are mainly indirect costs such as
your accountant’s salary that cannot be directly attributed to sales (except sales of
someone else’s paper).
WHEN COSTS VARY
Products purchased or manufactured in, say, July might not be sold until November. The
actual purchase or production is recorded in July, the product lives on the balance sheet
as ‘inventory’ until November, when the appropriate amount is charged to cost of sales.
Figure 8.7 shows how your inventory level is derived mechanically from your produc-
tion/purchases and your sales forecasts. The timing differences between the two might
raise a slight problem. How do you value the cost of sales if:
unit costs are changing over time; and
you do not or cannot match specific units of product to specific sales?
There is no easy, simple answer, as discussed next.
VALUING INVENTORY
Accountants use the following four methods to value the things that you sell.
Unambiguous inventory
Inventory in the present context is your stockpile of unsold raw materials, work-in-
progress, finished goods and services that you intend to sell. I sense that you are
wondering whether to quibble about whether you can have a stock of services. I
think that you could, for example, have an inventory of computer software if this
is your business. This is trading inventory. It is not what you have in your stationery
store cupboard (unless you are in the office supplies business) and it is not your
stock of fixed assets (such as machinery and equipment).
Incidentally, this is a situation where I favour the US inventory, which is much
less ambiguous than the British word stock. This could also refer to a unit of stock,
which is what Americans call shares and I generally prefer to call equity – to avoid
another ambiguity.
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182 CHAPTER 8 GETTING TO GROSS PROFIT
1Specific unit costs
Specific unit costs (also called specific identification) is where you match exactly the origin
of each unit of your product and journey into, through and out of inventory. This is the
purest method of valuation, but it cannot be used when units of your product are indis-
tinguishable from each other (grain, paint, talcum powder, jelly beans).
2Averaging
This is also called weighted averaging where each unit of inventory is measured by:
1 adding up all the money spent acquiring inventory during the period (the value of
the opening stock plus production/purchase costs); and
2 dividing the total calculated in step 1 by the number of items available for sale
(opening quantity plus quantity purchased/produced).
3FIFO
First-in first-out (FIFO) is where you track specific unit costs and assume that the earliest
items put into stock are the first ones removed. (This is one situation where an accounting
concept matches real-life common sense.)
Figure 8.7 Tracking inventory
Jan Feb Mar …
Volume, units
… … … … …
Production (or purchases)
Production volume, units 12 000 12 000 6 000 …
… … … … …
Inventory volume, units
Opening stock 5 000 7 000 8 000 6 000
Add production 12 000 12 000 6 000 …
Less sales 10 000 11 000 8 000 …
End-month stock 7 000 8 000 6 000
… … … … …
Sales
Sales volume, units 10 000 11 000 8 000 …
… … … … …
COST OF SALES 183
4LIFO
Last-in, first-out (LIFO) is where you track specific unit costs and assume that the latest
items put into stock are the first ones removed. (Unfortunately, this is similar to my docu-
ment filing system.)
You often find companies using a mix of valuation methods for various categories of
inventory. By and large, the first two or three techniques are preferable for analytical pur-
poses. The second two may be more advantageous for tax reasons. Use of LIFO results in
the lowest tax bill, although it is not accepted by some tax authorities (for example, in cer-
tain European countries).
When stock acquisition costs are rising (perhaps due to inflation), FIFO boosts the
value of your closing stock. When prices are falling (such as with many high-tech items
and some commodities), LIFO produces a higher valuation for the cost of goods sold and
a lower value for closing stock. Figure 8.6 contrasts the effect of using FIFO and LIFO in a
computer business where production costs are falling over time.
Clearly, inventory valuation is an example of where the books can be manipulated
even when no money is changing hands.
There are three other points that will come to mind when you are thinking about inven-
tory. These are discussed under risks in Chapter 11.
1 You want to keep inventory as low as possible – it ties up cash that for the moment
is not earning for you.
2 Adequate opening and closing stocks do not automatically imply that you can
meet demand during the month – if sales run ahead of production there might be
an unacceptable delay in meeting orders.
3 You need a buffer stock to meet unexpected changes in demand.
When is a sale not a sale?
Mischievous managers frequently recognise sales when it suits them. If revenue is
running above budget in November or December, a big end-year contract could be
booked in January. The year comes in on target and there is a good start to the next
one. Alternatively, but more difficult, if income is poor this year it might be boosted
by moving back a sale from early next year. I trust you to be honest, but if you are
checking someone else’s figures this is a trick to watch out for.
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