Cost of Goods Sold vs Inventory Asset

What is Inventory versus Cost of Goods Sold? Why is inventory important? What do you need to know about Inventory to operate your jewelry business? You’ll find all these answers here.

What is Inventory?

Inventory is an Asset, and Assets are things you own, like cash in the bank. Inventory Asset includes Raw Materials, Works in Process and Finished Goods that are available for production or sale. You’ll often hear “Inventory on hand”, “Inventory in stock” or “Standing Inventory” and they all mean the same thing: products that you have that you can sell to create cash.

Just like cash in the bank, the total balance of Inventory Asset is a rolling number that goes up or down based on purchases and sales during a given period, such as month to month, or over a year’s time. In your financial reports, you’ll find the Inventory Asset account under current assets on the Balance Sheet with the other things your business owns. If you have a Balance Sheet and no Inventory value, but you do actually have inventory in stock, it means you’ve been expensing your inventory during the year that you purchase it.

When Finished Goods are made in-house from purchased Raw Materials (metals and gemstones) and Labor, then the outside or employee Labor attributed to that Finished Good is also part of the Finished Good Asset. Please note that labor here cannot be your own labor if you are a maker and must only be direct costs of labor for the production. Your labor as the owner, even if you are a corporate entity and are an employee of your business, cannot be part of this calculation. If you have dedicated Bench Jewelers on payroll or as contractors, or a production house that charges labor separately, then these costs are part of inventory. Your labor is part of the profit margin and the net income part of your taxable income, let’s call it your paycheck.

Inventory Asset has a counterpart: Cost of Goods Sold. Inventory is what you have, while Cost of Goods Sold is the Inventory that went out the door with a sale.

What is Cost of Goods Sold?

Cost of Goods Sold (COGS) is the inventory and production labor cost of what sold during a given period. Where the labor is attributable to an item in inventory along with its material cost, that item and its labor will be expensed as COGS when the item sells. Hence, Cost of Goods SOLD.

Both Inventory Asset and COGS are the paid cost of the items you buy for resale. Whether you sell at wholesale or retail, your COGS will always be the product purchase cost of those sales. Your markup is the profit margin between your revenues or sales income minus the COGS of those sales.

Cost of Goods Sold (COGS), is found as a direct expense of your business’ income on the Income Statement, aka the Profit & Loss Report. You’ll see it in the section right above the Gross Profit.

EXAMPLE 1:

Let’s take the month of December 2021. In December, you sell a lot of goods and are flush with cash to buy more goods for the coming year of 2022. The goods you sold in December were all items you purchased in 2021. But now you have a lot of inventory that you won’t sell until 2022. All of the new purchases and whatever is left in stock from prior purchases will be the balance in Inventory Asset as of Year End 2021. Only the cost of what sold in 2021, will be expensed in Cost of Goods sold to offset your income earned. That way, all of the costs you have on hand, will be expensed later, when those goods actually sell in order to offset their relative income.

Why are Inventory and COGS important?

As a product-based business, inventory is the most important component of your business because it is the core generator of income. All other departments circle around this revenue generator: Sales, Marketing, Operations, Accounting, and Production depend on the products being sold.

Your pricing is dictated by your Inventory. Where you’re sourcing it from and who your customer is are major factors.

In financial reporting, being able to see this number correctly, can help to identify where something in your business isn’t working and where improvements may be needed. Factors like production labor or sales concentration. Accurate recording allows you to drill down and address specific operations or modify the focus of the business.

What to know about Inventory and COGS to operate:

To have a productive, streamlined and efficient business, you need to know what you have sitting available for sale, and what you need to create future sales.

Tracking inventory is tedious in the jewelry world, but without it, you’re likely to go to Tucson and return with items that may not have a buyer for years. Whether it’s because you forget you even have an item among the chaos (out of sight out of mind), or maybe because it doesn’t align with your brand or isn’t sought after by your customers if you aren’t explaining its purpose for them.

Knowing what you have and what you need is the basic requirement for inventory.

On the front lines of your business: in your workshop and on the sales floor, be it physical or eCommerce, you must have the right goods at the right time at the right price. This all depends on your understanding of your products, their pricing, and who you’re selling to.

Central Command:

It is important to have one master location that tracks your purchases and their conversion costs into finished goods to help you order and price. This is often a spreadsheet, a Point of Sale (POS) program, or an inventory app. You need one place to turn to and see everything you have in Materials, Standing Inventory, and out on Consignment or Memo.

Revenue Streams:

Simplify your outputs and inputs by reviewing where you make your sales, and what revenue streams are worth keeping. As with anything, focus is required for success. Review your line, or collections, for opportunities and weaknesses to dump what is taking your time for little return. Review how sales are coming in. There is no need for multiple payment methods and eCommerce platforms if they aren’t performing. Identify what is working and get rid of the rest.  

Cost Benefit:

In the back office of your business, accounting and financial management, the number of 18 gauge jump rings you have in 14 karat vs sterling silver is not important. The only concern in accounting is the price: what was purchased and what sold. That doesn’t diminish the importance of those jump rings in production; it’s just that the detail isn’t required in all departments of the business.

Tying inventory management to accounting can be difficult in a production-based business, but does not need to be complicated. When you’re buying and selling the same thing, think T-Shirt or Finished Goods from Wholesalers, then it’s super easy, because the same Item you originally bought is the same item used in the sale. The cost to track this is very minimal. The items purchased should map easily to the sold items, one to one.

However; when you are making one product from many different items and need to map together different materials and labor to a finished piece; this is where most Accounting programs need to work together with a more robust Inventory Management system. This is called a Bill of Materials or Assembly to map these costs to a sold item.

Should I do Inventory on Cash or Accrual:

Cash is the actual of what happened in the bank, while Accrual is what is expected to happen.

For income tax purposes, small businesses with average annual revenues (top line Sales Income) under 25 Million are not required to report inventory on accrual and can expense all purchases as COGS in the year items are purchased. (ref: https://www.irs.gov/pub/irs-pdf/p538.pdf)  That said, it really doesn’t make sense for any product based business to not track their inventory.

A hybrid based system is nice for small businesses that want to even out their taxable income year over year. This is where you operate on cash basis, the method of accounting where only what has processed through the bank is what is counted, but inventory is done on accrual to match what the cost of goods to what actually sold. This way, you don’t have to worry about paying tax on income not yet earned for invoices sent out to wholesalers, for example before they’ve actually paid. But you are moving out of Inventory Asset only the cost of what sold to offset the Sales Income. This is helpful to prevent fluctuations in tax liability caused by buying more in one year than the next, or less income in one year and more in another.

The purchases that haven’t sold are in Inventory Asset and only the Cost of What Sold is in Cost of Goods Sold.

EXAMPLE 2:

Let’s say in 2021 you buy a lot of inventory, but you don’t make a lot of sales income and didn’t sell everything you’ve bought. You expense all your purchases of inventory from that year and show a Net Loss.

The next year in 2022, you sell everything you bought in 2021 and didn’t need to buy anything else. Since you already expensed all the inventory in 2021, the year it was bought on your taxes, this now means you have nothing to offset the 2022 sales income. This means your taxable income, and therefore your tax liability in this year will be much higher and likely not anticipated. You got the tax deduction in 2021, so you underpaid on income that year. In 2022, you don’t get the tax deduction again because you already took it the year before, so you overpay on income that year in order to even out how your costs actually occurred. By not tracking Inventory and expensing only the cost of what sold, your taxable income is directly impacted, whereas when you do track it and expense appropriately, your taxable income is more even.

Benefits of Tracking Inventory:

When you have stable pricing and expense as sold, you have a more predictable tax liability, and the profitability of the business is not over- or under-stated.

If you keep buying goods and expensing them in the year they are bought, you’ll never have a clear picture of your business’s financials.

When there is a problem in your purchasing (over buying), supply chain sourcing, or pricing markup, it will be apparent on your financial reports when Inventory is being tracked.

When you have assets on the books, the inventory can be turned into cash through sales. This increases your stance as a viable business. Whereas a consistent net loss year over year because purchases are being expensed as they occur, is not a recipe for healthy financials. If you have need to provide your financial reports for a home loan or otherwise, having the inventory accrued instead of recording a loss would be preferred.

Here are ways to calculate your actual Cost of Goods:

1. Do a physical Inventory. If you’re trying to correct your inventory from expensing it in full in the past, then only your purchases for the current year matter. Anything else has already been expensed for tax purposes and doesn’t matter. But in your inventory system, it does matter! You’ll need to differentiate it from active deductible inventory with perhaps a zzz prefix to the sku code or Item Name. All Costs are the lower of your original purchase price or Fair Market Value (wholesale purchase cost, not retail!). Your original purchase price is always preferred.
2. Calculate the Cost of the Actual Sales. List out all the costs of what sold. Total them up. This amount is the Cost of Goods Sold on your Income Statement and the balance of all purchases over that amount should be in Inventory. (Exception for previously expensed items in a prior tax year. Don’t double dip! Only move new purchases left over to Inventory if that is the case.)
3. Calculate the Cost of Sales using estimation by backing out the cost of goods from the Revenues. Take your total Retail Sales Income and back out the markup from Wholesale. Take this and your total Wholesale Sales Income and back out the markup between Wholesale to Cost. This will give you your COGS for those sales. Ex (Retail Sales $400,000 in 2019 divide by 2.3 to get to wholesale, is $173,913. Then you also have $100,000 in Wholesale Sales, so 273,913 divided by your markup of 2 is 136,957. Your Cost of Goods Sold for $400k in Retail and $100k in Wholesale is $136,957 or a 72% profit margin with 27 cents of every income dollar going to COGS). Note: you may need to leave out your labor from your pricing formula if your labor is part of that.

You should refer to your most recent filed income tax return to see what was recorded as the Ending Inventory. That will be your Beginning Inventory for the Current Year.

Add: Purchases

Add: Labor (not your own, unless you solely do Bench Labor and are on Payroll as an S-Corp or Corp paying Payroll Taxes from your business)

Less: Cost of Goods Sold

Ending Inventory for the Current Year.