Small-business owners strive to have profitable businesses. To know whether they are truly profitable, they must use accurate figures to evaluate profitability.
One of the most important figures on a business’s income statement is the Cost of Goods Sold (COGS).
But many times when my clients and I are discussing profitability, I find that their records are not giving them a true picture of their COGS. I learn that they are looking at what they spent on inventory purchases throughout the year and are not really comparing the cost of what they actually sold with their sales figures.
They have simply recorded the amount of inventory purchases throughout the year and used this as COGS. This does not take into account the amount of inventory the business still has at the end of the year or what was present at the beginning of the year.
To accurately calculate your COGS, you would take the cost of the inventory you had on hand at the beginning of the year and add the inventory purchases you made throughout the year. Then, you would subtract the cost of the inventory you still have on hand at the end of the year.
This means you will need to conduct an actual physical count of inventory at the end of each year. You will then know your ending inventory for a given year and your beginning inventory for that same year (the last year’s ending inventory count).
This will allow you to compare the cost of the inventory you actually sold to your sales figure. You can then obtain your gross profit by taking your sales for the year and subtracting COGS. To look at net profit for the year, you would then subtract your operating expenses from the gross profit.
When you express your gross profit as a percent of sales, you get your gross profit margin. Having an accurate gross profit margin allows you to compare your business’s performance to industry averages and look for significant differences that may indicate the need to change how you are operating.
You also can compare gross profit margin from year to year to see how the business is performing over time.
While conducting this physical inventory count helps you have a more accurate COGS figure for the year, you really should be looking at your numbers more often. This will help you to better operate and manage your profitability throughout the year.
So, although a physical inventory count can be a lot of work and time consuming, you really need to do it on a regular basis to get an accurate indication of the profitability of your business and make key decisions that will affect your bottom line.
Connie Edwards is a business consultant with the University of Georgia’s Small Business Development Center. Contact her at 651-3200.