3 keys to profitability: cost of goods sold, markup, and margin

Stan Synder Stan Snyder, CPA and expert bean counter

Margin and markup are terms that are commonly used in retail businesses. They are also commonly misused and misunderstood.

For a business that sells products, the wholesale cost of the product sold is known as cost of goods sold or the cost of sales. Margin is the difference between the sales price of the product and the cost of the product. Markup relates to the process of calculating the price of the product based on its cost. Understanding these three terms and how to calculate them are keys to maximizing your gross profit and net income while remaining competitive.

This article will present five concepts that you need to know to understand cost of goods sold, margin, and markup. The concepts are:

  1. Cost of goods sold
  2. Standard financial statement format
  3. How inventory fits into the equation
  4. Gross profit margin
  5. Margin and markup

Cost of goods sold: one of three types of expenses

In the accounting world, there are three overall categories of expenses: cost of goods sold, operating expenses, and extraordinary expenses. This article deals with the first category, cost of goods sold. Cost of goods sold is the direct cost of the products and services your business sells. This includes the cost of labor and overhead to produce the goods and freight to obtain the goods. Cost of goods sold can be directly identified in the end product. For a mason, the cost of bricks and mortar is a direct cost. These costs are directly identifiable as a part of the product produced.

The cost of insurance, fuel, and maintenance for the trucks used to carry the bricks and mortar are indirect costs. While these costs are part of the product produced and are incurred in the process of generating revenues, they cannot be identified as belonging to a specific job or product. Indirect costs such as heat, light, power, and rent are also known as operating expenses or overhead.

Operating expenses are listed under expenses in the profit and loss report. Only the direct cost of the product is included in the calculation of cost of goods sold, margin, and markup. The cost of good sold varies directly with the volume of goods sold; each sale adds to cost of sales. Operating expenses, on the other hand, are relatively fixed. The business will pay the same amount of rent and utilities whether 10 items or 100 items are sold.

Understanding the standard financial statement

Cost of goods sold and operating expenses are shown in separate sections of the profit and loss report. First, the statement shows revenues, followed by cost of goods sold. Cost of goods sold is subtracted from revenues to produce gross profit. Expenses are then summarized, totaled, and subtracted from gross profit to calculate net income from operations. Finally, extraordinary items — such as the gain or loss on a sale of fixed assets — are added or subtracted from net operating income to yield net income. The standard format for an income statement is therefore as follows:

Profit and loss statement

The term revenue refers to amounts generated from the sale of goods and services. Cost of goods sold is the direct cost of the items sold. Operating expenses refer to the ordinary and necessary costs — other than direct costs — of running the business. These distinctions are important not only in presenting information in a standard format, but also in analyzing business profitability.

How inventory fits into the equation

Calculation of cost of goods sold involves another account, inventory. When goods are purchased for resale, the cost is not recognized immediately. When goods are purchased, an increase in the inventory asset is recorded on the balance sheet. The cost of a sale is not recognized or reported on the profit and loss report until the sale is concluded. Calculation of the cost of goods sold is therefore inextricably intertwined with inventory. The formula for calculating cost of goods sold is a logical and straightforward one:

  • Beginning Inventory + Purchases = Goods Available for Sale
  • Goods Available for Sale - Ending Inventory = Cost of Goods Sold

Calculation of cost of goods sold in a Profit and Loss statement

Purchases of goods add to the balance in inventory and each sale reduces the inventory, but we don't know the amount of the reduction — the cost of the goods sold — without specifically identifying the cost of each item as it is sold. You can calculate the cost of goods sold by taking a physical count of the ending inventory and subtracting the cost of the ending inventory from goods available for sale.

 Note   Using Office Accounting, you can calculate cost of goods sold in two very different ways: by using the above formula, by coding purchases to the inventory account and adjusting inventory when a physical inventory count is taken, or by tracking the cost of each item as it is purchased and sold and using a physical count to verify the balance in inventory.

Office Accounting uses two different types of items to track the products your business sells:

  • Non-inventory items track information only about the cost and sales price of each product, ignoring the inventory account and forcing the user to manually adjust the inventory balance at the end of each fiscal period.
  • Inventory items, on the other hand, track information about each product as it is purchased and sold, increasing the inventory with each purchase and decreasing the inventory account — and increasing cost of goods sold — with each sale.

The gross profit margin

Now that we have a fundamental understanding of cost of goods sold, we can discuss more interesting things like profit. The term gross profit margin refers to the ratio between revenue and gross profit. If the business is said to have a low margin, such as a grocery store, it means that the cost of sales is high in relationship to revenues. The margin, or difference between revenues and cost of sales, is low. Businesses with a low margin need to make up for the low margin with a high volume of sales. Businesses with a high margin, such as a jewelry store or a high-end clothing store have a low cost of sales compared to revenues.

Knowing the cost of sales for your industry is critical to maximizing your profit. Consider the following businesses, both with identical revenues and operating costs:

Comparison of the net income for two companies with one percentage point difference in cost of sales

XYZ Company, with cost of sales 2% higher than ABC Company, makes a $365,000 profit. ABC Company, with a 2% lower cost of sales, generates an additional $70,000.00, an increase of 19% in net income. Because they pay close attention to their cost of sales, ABC Company has a higher gross profit margin and is substantially more profitable than XYZ Company.

Margin and markup: two ways of looking at the same thing

Markup is the term with which most retailers are comfortable. Markup is based on cost. A retailer multiplies a percentage — known as the markup — times the cost of a product to calculate the sales price for the product. While markup and margin refer to the same thing, they're calculated differently. Markup is based on cost, and margin is based on revenue. A 100% markup becomes a 50% margin. With a cost of $1.00 and a 100% markup, the markup is $1.00 and gross revenue is $2.00.

Relationship between markup and margin

The markup is 100% of the cost (markup of $1.00/Cost of $1.00=100%). However, the margin is 50% — the markup divided by gross revenue (markup [or gross profit] of $1.00/Revenue of $2.00=50%). While markup and margin refer to the same thing, markup is calculated based on the relationship of gross profit to cost while margin is calculated based on the relationship of gross profit to revenue.

How to use margin and markup to become more profitable

Business owners use markup to calculate the sales price for individual goods. Accountants and analysts use the gross profit margin to view the overall profitability of a business.

Small business associations publish financial statements that summarize the results of operations for their members. These publications are wonderful sources of information that reveal a wealth of financial details including average profit margins for the industry. If you don't know the expected gross profit margin percentage for your business, don't you think you should? Join an industry association, or search the Internet for more details about expected profit margins in your industry.

Knowing the average gross profit margin for your industry will help you to compare your business to other businesses in your region and remain competitive. Tracking the changes in your actual gross profit over time will help you to price your products to maximize gross profit and net income.


About the author

Stan Snyder is a certified public accountant with over 25 years experience dealing with the accounting and computer problems that small business owners face. He teaches computerized accounting classes at Colorado Mountain College, and regularly consults with small business owners using accounting software of all types. If you have questions about this topic or another accounting topic, send Stan some feedback by responding to the question below "Was this article helpful?" Stan may use your questions or topic ideas in an upcoming column.

 
 
Applies to:
Accounting 2008