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How to Read a Financial Report: Wringing Vital Signs Out of the Numbers by John A. Tracy

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5
COST OF GOODS SOLD EXPENSE
AND INVENTORY
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34 Cost of goods sold expense and inventory
Holding Products in Inventory Before They Are Sold
Please refer to Exhibit 5.1 at the start of the chapter. (Chapter 4
explains the design of this exhibit, which is also used in following
chapters.) This chapter focuses on the connection between cost of
goods sold expense in the income statement and the inventory asset
in the balance sheet. Recall that the business in the example sells
products, which are also called goods or merchandise.
Cost of goods sold expense means just that the cost of all
products sold to customers during the year. The revenue from the
sales is recorded in the sales revenue account, which is reported
just above the cost of goods sold expense in the income statement
(see Exhibit 5.1 ). Cost of goods sold expense is by far the largest
expense in the company s income statement, being almost three
times its selling, general, and administrative expenses for the year.
Putting cost of goods sold expense fi rst, at the head of the
expenses, is logical because it s the most direct and immediate
cost of selling products. Please recall that this expense is deducted
from sales revenue in income statements so that gross margin is
reported there see Exhibit 2.2 for an example of an income state-
ment. Although gross margin is not shown on a separate line in
Exhibit 5.1 , in order to focus on the key connections of income
statement and balance sheet accounts, I can t emphasize enough
the importance of gross margin (also called gross profi t).
The word gross emphasizes that no other expenses have been
deducted from sales revenue yet. Of course, there are more expenses
that must be deducted before arriving at bottom - line profi t (net
income). Gross margin is the starting point for earning an adequate
nal, bottom - line profi t for the period. In other words, the fi rst step
is to sell products for enough gross margin so that all other expenses
can be covered and still leave an adequate remainder of profi t. Later
chapters discuss the company s other expenses.
You can do the arithmetic and determine that cost of goods sold
expense equals 65% of sales revenue. Therefore, gross margin equals
35% of sales revenue. The business sells many different products,
some for more than 35% gross margin and some for less. In total, for
all products sold during the year, its average gross margin is 35%
which is fairly typical for a broad cross section of businesses. Gross
margins more than 50% or less than 20% are unusual.
To sell products, most businesses must keep a stock of prod-
ucts on hand, which is called inventory . If a company sells
products, it would be a real shock to see no inventory in its
balance sheet (it is possible, but highly unlikely). Notice in
Exhibit 5.1 that the line of connection is not between sales
revenue and inventory, but between cost of goods sold expense
and inventory. The inventory asset is reported at cost in the
balance sheet, not at its sales value.
The inventory asset account accumulates the cost of the prod-
ucts purchased or manufactured. Acquisition cost stays in an
inventory asset account until the products are sold to customers.
At this time, the cost of the products is removed from inventory
and charged out to cost of goods sold expense. (Products may
become nonsalable or may be stolen or damaged, in which case
their cost is written down or removed from inventory and the
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