How to work out cost of sales and gross profit

Cost of sales is what the goods sold in the year cost the business. It is also called cost of goods sold. Gross profit is the profit on trading, before the running expenses of the business.

Purchases alone are not the cost of the goods sold. Some of the goods sold this year were bought last year. Some of the goods bought this year are still on the shelves.

Revenue

Sales less sales returns.

Opening inventory

The goods held at the start of the year. It is last year's closing inventory.

Purchases returns

Goods sent back to suppliers. They are taken off purchases.

Carriage inwards

The cost of getting bought goods delivered to the business. It is part of cost of sales.

Closing inventory

The goods still unsold at the year end.

Carriage outwards is the other way round: the cost of delivering goods to customers. It is a cost of selling, so it is an expense below gross profit and is not part of cost of sales.

Sales, sales returns, purchases, purchases returns and carriage inwards are balances in the ledger at the year end.

Opening inventory is in the ledger too. The inventory account is not touched during the year, so a trial balance taken before the adjustments still shows the figure from the last year end.

Closing inventory is not in the ledger. During the year every purchase is debited to Purchases, so the ledger has no record of what is left. The only way to know is to count, at the close of business on the last day of the year.

Each line of the count is valued at the lower of its cost and its net realisable value. Net realisable value is the expected selling price, less any costs still to be paid to make the sale.

A journal then puts the figure into the books: debit Closing inventory in the statement of financial position, credit Closing inventory in the statement of profit or loss. The credit is what reduces cost of sales.

1. Work out revenue: sales less sales returns.
2. Start the cost of sales with opening inventory.
3. Take purchases returns from purchases, and add the result.
4. Add carriage inwards. The total so far is the cost of everything that was available to sell in the year.
5. Take away closing inventory. Goods still on the shelves have not been sold, so their cost is carried into next year. What is left is the cost of sales.
6. Take the cost of sales from revenue. The answer is the gross profit.

The order matters for one reason: each line needs the one above it. Gross profit cannot be found until the cost of sales is known, and the cost of sales cannot be found until the inventory has been counted.

Bracken Outdoor is a camping shop. In the year it made sales of £61,200.00 and customers returned goods worth £1,200.00. Revenue is £60,000.00.

Inventory at the start of the year was £6,300.00. The year-end count comes to £7,150.00. The shop also paid £480.00 to deliver tents to customers.

Purchases less returns plus carriage inwards is £38,150.00. With opening inventory of £6,300.00, the goods available to sell cost £44,450.00. Less closing inventory of £7,150.00, cost of sales is £37,300.00.

Gross profit is £60,000.00 less £37,300.00, which is £22,700.00. The £480.00 of carriage outwards is not in this working. It is listed with the other expenses, below gross profit.

Closing inventory feeds straight into profit. Any change in cost of sales changes gross profit and net profit by the same amount.

Suppose a recount finds that Bracken's closing inventory should be £300.00 higher. Cost of sales falls to £37,000.00 and gross profit rises to £23,000.00.

So closing inventory that is overstated makes this year's profit too high by the same amount. The same figure is next year's opening inventory, where it has the opposite effect: next year's cost of sales is too high and its profit too low.

• Adding closing inventory and taking away opening inventory. It is the other way round: opening is added, closing is taken away.
• Putting carriage outwards in cost of sales. Only carriage inwards belongs there.
• Adding purchases returns, or leaving them out. Goods sent back were never sold, so they come off purchases.
• Using sales before returns. Revenue is sales less sales returns.
• Valuing the count at selling prices. Inventory is valued at cost, or at net realisable value if that is lower.
• Leaving goods the owner took in purchases. Goods taken for the owner's own use are drawings. They come out of purchases at cost, because they were never sold.

• Opening inventory is the same figure as last year's closing inventory.
• Cost of sales plus closing inventory equals opening inventory plus purchases, less purchases returns, plus carriage inwards.
• Gross profit plus cost of sales equals revenue.
• Carriage outwards appears once, among the expenses below gross profit.
• Closing inventory appears twice: as a deduction in cost of sales, and as a current asset in the statement of financial position.