Determining profitability accurately is essential for any business to gauge its financial performance. Selling is an important function of any business entity whose core goal is profit maximization. Apart from maximizing sales, controlling costs is also essential to maximize profitability. Gross profit determination is the first and critical step in analyzing profitability, especially in manufacturing entities.
This article looks at meaning of and differences between two important components that are need to calculate gross profit- sales and cost of goods sold.
Definitions and meanings
Sales is the revenue generated by a business through provision of goods or services to its customers. In the case of manufacturing and trading entities sales revenue is generated by selling their products to various customers. In case of service entities, sales revenue is generated by providing services of various kinds to customers.
The formula for calculating the monetary value of sales is:
Sales in case of a goods providing entity = No. of units sold × sale price per unit
In the case of a service entity, sales can be calculated on several methods such as lumpsum basis, milestone basis etc.
The above formula is a basic formula for calculation of sales before computing any cash discount.
Accounting for sales under accrual method – an example
M/s ABC Inc is a mobile phone manufacturing entity. During April 2020, it has manufactured 200 mobile phones. Out of these 200 phones, the company has sold 150 phones to distributors with 50 phones remaining in stock. Each phone was sold for $120 and sales tax @ 10% has been charged. The accounting entry recorded for sales is as follows:
Accounts receivable 19,800 [Dr.]
Sales (150*120) 18,000 [Cr.]
sales tax payable 1,800 [Cr.]
As can be seen, sales are recorded at pretax amount and sales tax is transferred separately to a liability account. Sales figure is an income and thus its ledger balance is transferred to and reported on the credit side of the profit and loss account.
Sales is the predominant component of any business’ revenue. Accounting for sales figures correctly is imperative as it is the basis for profit determination.
Cost of goods sold
Cost of goods sold is the expense involved in producing or acquiring marketable goods that have been sold.Cost of goods sold includes cost of raw materials, direct wages, overheads attributable to the production process and any other conversion costs involved in producing finished, saleable goods.
All individual components of cost of goods are recorded as separate expenses in the profit and loss account. The cost of goods pending to be sold are not expensed out but carried in the books as closing inventory.
The calculation of cost of goods sold is dependent on the inventory valuation method followed by the entity.
The formula is:
Cost of goods sold = Value of opening inventory + cost of additional entry produced/acquired during the period – value of closing inventory
Continuing the above example, the total costs incurred by ABC Inc during April 2020 include:
- Direct materials: 5,000
- Direct labor: 3,000
- Machining costs: 2,000
- Administrative costs: 500
- Marketing costs: 1,000
- Distribution costs: 1,200
Opening inventory is valued at $3,000 and closing inventory is valued at $2,700
The value of cost of goods sold = 3000 + (5000 + 3000 + 2000) – 2700
Comparing the sale and cost of goods sold helps determine the gross profit margin that a business makes. Analysis of cost of goods sold is also essential for determining pricing policies and actions for controlling costs.
Difference between sales and cost of goods sold
The key points of difference between sales and cost of goods sold have been detailed below:
- Sales is the monetary value of income earned by an entity by selling its products and/or services.
- Cost of goods sold is the sum total of all expenses incurred by the entity to produce the goods it has sold.
2. Accounting classification
- Sales is a revenue for an entity and is classified as ‘income’.
- Cost of goods sold is a summation of several costs and is thus classified as an ‘expense’.
3. Presentation in financial statements
- Sales are recorded and reported on the credit side of the profit and loss account.
- Cost of goods sold is not separately disclosed in the profit and loss account. It is in fact calculated by considering several costs recorded in the profit and loss account.
4. Accounting entry
- Sales are typically accounted for by a single accounting entry.
- Cost of goods sold is not accounted for by any single accounting entry. Separate accounting entries are passed for various components of cost of goods sold.
5. Complexity of calculation
- The calculation of total sales is fairly straightforward. It is calculated by multiplying the total number of units sold by the per unit sales price of each unit sold.
- The calculation of cost of goods sols is more complex as it is a summation of several different components. This may also include allocation of expenses.
6. Impact on profitability
- Sales have a direct relation to profitability. Increased sales increase profitability and vice versa.
- Cost of goods sold has an inverse relation to profitability. Increased cost of goods sold decreases profitability and vice versa.
- If value of sales achieved are higher than cost of goods sold, then the entity has earned a gross profit.
- If cost of goods sold are higher than value of sales achieved, the entity has recorded a gross loss.
- Analysis of sales data is useful in profitability analysis and in determination of sales and marketing policies for maximization of sales.
- Analysis of cost of goods sold is useful in taking pricing decisions and driving policies for cost control and cost reduction.
- Sales value can be controlled to certain extent by altering sales price or by effecting sales volume by driving marketing efforts.
- Cost of goods sold can be controlled by implementing policies for cost control and cost reduction.
Conclusion – sales vs cost of goods sold
While both sales and cost of goods sold are often analysed individually for several economic analysis, the first and foremost analysis is a comparison of the two figures to determine gross level of profitability.Maximization of sales and minimization of cost of goods sold must happen simultaneously if an entity seeks to maximize its profitability.