Inventory is something that confuses a lot of people. It should be an expense. After all, inventory is something you sell. It costs you money to buy or to manufacture. So, why isn’t it considered an expense or a liability to your business? Why does it appear on your Balance Sheet as an asset?
Well, actually inventory is both an asset AND an expense. It’s all a question of timing.
When you buy or manufacture inventory for your business you are creating an asset. It’s worth something. As you buy or manufacture more inventory, the overall amount goes up in value. As long as the inventory remains unsold, it’s considered an asset.
It’s only through the process of selling the asset that you can begin to offset the expenses involved in buying or creating it against the income you generate from its sale.
How to Calculate COGS (Cost of Goods Sold) for Your Business Inventory
With inventory, it’s critical that you know the cost where you start and the cost where the year ends. Your inventory value may go up and down during the year, but those two costs are key. You can’t calculate your COGS without knowing those two numbers.
The formula for COGS is:
COGS = Beginning Inventory + Purchases – Ending Inventory
Your COGS amount is important, because it hits your financial records. If you underestimate your COGS, your inventory looks like it’s worth more on paper. But if you overestimate it, your inventory becomes undervalued. Neither is particularly good, because they don’t show you a true, accurate picture of your business’s value.
You may also have COGS without an inventory. For example, let’s say you have a service business. You hire others (a COGS of your business), which is an expense against the money you make. No inventory here! But there is still a COGS.
Inventory is one several financial indicators business owners must learn to understand and analyze. Actually knowing what the information translates into for your organization will give you the power to make accurate tactical decisions. But don’t fall into the trap of thinking it is your responsibility to prepare financial reports.
As a business owner, it is critical that you recognize that your time and efforts should be aimed at designing long term strategies that will ultimately result in growth and profit for your organization.
Financial reports are the best tool you have to determine how long it will take your business to reach its goals, but preparing them should not consume your time. If you are ready to receive timely and accurate financial reports you can rely on, please contact us. Cash Flow Accounting offers many different options that will take care of your bookkeeping needs. We are an affordable, accessible solution. Our Interactive accounting model will reduce your costs and provide the information you need to point your business in the right direction. For more information, please contact us at Info@CashFlowAccounting.com .