Profit is sales minus the cost of the goods you actually sold, not sales minus everything you bought. The cost of the goods sold is called COGS, and the usual way to work it out in a trading business is weighted average cost.
Why is "sales minus purchases" wrong?
It is wrong because purchases include goods that are still on your shelf. Suppose in one month you buy goods for Rs 1,000,000 and sell goods for Rs 700,000. Sales minus purchases says you lost Rs 300,000. In fact you may have sold only half of what you bought, at a good margin, and the rest is stock you still own.
The opposite mistake also happens: in a month when you buy little and sell old stock, sales minus purchases shows a profit that is not real.
What is cost of goods sold (COGS)?
Cost of goods sold is what the items on this month's sales invoices cost you. It counts only goods that left the shop.
Gross profit = net sales − cost of goods sold. Net profit is gross profit minus expenses such as rent, salaries and transport.
What is weighted average cost?
Weighted average cost is the average cost per unit of the stock you hold, weighted by quantity. Each time you buy, the average is recalculated:
New average = (value of stock in hand + value of the new purchase) ÷ (quantity in hand + quantity bought).
How does it work in an example?
| Step | Quantity | Cost per kg | Stock after | Average cost |
|---|---|---|---|---|
| Opening stock | 500 kg | 700 | 500 kg | 700.00 |
| Sale | 250 kg | leaves at 700 | 250 kg | 700.00 |
| Purchase | 1,000 kg | 760 | 1,250 kg | 748.00 |
After the purchase: (250 × 700 + 1,000 × 760) ÷ 1,250 = 748. The next sale leaves stock at 748 per kg.
The sale of 250 kg at a rate of 850 earned 250 × (850 − 700) = Rs 37,500 gross profit. The purchase of 1,000 kg did not change that profit at all; it changed your stock.
Why does average cost suit a wholesaler?
It suits a wholesaler because identical goods bought at different rates are mixed on the shelf. You cannot say which bag of cement came from which truck. The average is fair, simple and does not jump when a rate changes for one consignment.
What else belongs in the cost of sales?
- Sales returns take their cost back out of COGS, because the goods are in stock again.
- Stock adjustments for damage or shortage are a cost; found stock is a gain.
- Supplier notes for a rate difference raise or lower the cost.
Owner drawings do not belong in it, and are not an expense either. See cash, bank, expenses and owner drawings.
In M-Tech Logistics: every sale records the average cost at that moment, so the profit and loss report shows net sales, cost of goods sold, gross profit, expenses and net profit for any period, and the Sales by Product report shows profit per item. See the reports or read which reports to check.