Miscalculating Expected Gross Profit by overlooking costs that should be included in Costs of Goods Sold (COGS) is a common error in business, leading to baffled business owners asking, “where have our profits gone?”
Let’s look at why
Gross profit is calculated by subtracting the cost of goods sold (COGS) from total revenue. If certain costs that should be included in COGS are overlooked or omitted, the resulting expected gross profit figure will be inaccurate and management will be surprised when they get the actual management accounts or statutory accounts.
Include all Related Costs
To avoid such surprises, It is essential to ensure that all relevant costs directly associated with producing the goods or services being sold are accounted for in the COGS calculation. Costs which are often overlooked can include, labour costs related to production but hidden in overheads, costs of utilities used in the production of goods that should be apportioned out of overheads, other transaction costs.
Timing issues, such as work in progress and inventory (stock) turnover (opening and closing balances) are two specific timing issues that can impact the accuracy of gross profit calculations.
Work in progress (WIP) refers to goods or services that are partially completed but not yet sold. When calculating gross profit, it’s crucial to consider the costs associated with these partially completed items and include them in the COGS. Neglecting to account for work in progress can lead to an inaccurate gross profit figure.
Inventory turnover refers to the rate at which a company sells its inventory and replaces it with new stock. It involves considering the opening and closing balances of inventory during a specific period. Failure to account for changes in inventory levels or not accurately reflecting the opening and closing balances can result in incorrect gross profit calculations.
If you ever wondered why your sales teams margins report differed from what your accountant tells you, now you know why!