The Importance of Properly Accounting For Inventory Purchases
Tracking inventory is a crucial aspect of managing a subscription box company. Without sufficient tracking of inventory purchases, your cost of goods sold expense will be incorrect and will lead to an incorrect understanding of your businesses’ true profitability. In this article I will provide a brief illustration of both proper and improper inventory tracking, and how each affects your Profit and Loss (P&L). Note that this article is a companion piece to my previous article ‘The Importance of Proper Revenue Recognition’. These are two crucial pieces that need to be done correctly to give you accurate financials.
Oftentimes products and packaging are purchased prior to the month in which they are shipped. As a result, cash leaves the bank account a month or more before the underlying box for which it was purchased ships. Under the cash basis of accounting, no adjustments are made to the books for when the cash leaves the bank account and when the inventory is actually shipped. This does not give the owner a correct view of profitability and leads to skewed financial statements. I will use the purchase of boxes in the following example. It’s important to note that errors can disguise themselves, if the timing of inventory purchases are consistent month to month. This can mask improper tracking of inventory because COGS may appear correct, but eventually the error will manifest itself. The following examples will assume a sales price of $30 and total cost of goods sold of $18 (this includes the box, printing and packing materials, products, etc.), for a gross profit margin of $12, or 40%.
When boxes are ordered in bulk and journal entries are not made in the books, cost of goods sold will be skewed in the month they are purchased, and all following months in which they are shipped. Let’s assume a business purchases 3,000 boxes for $3,000 in December, and these boxes will not be needed until January (when 100 of these boxes are shipped). Under the cash basis method, this $3,000 purchase gets expensed in December. Under the accrual method, this $3,000 would get expensed in the months they are actually shipped in (in this example, 100 per month beginning January 2020 until the boxes are exhausted). Here’s an example of a cash basis P&L for the month of December without any adjustment being made for the purchase of the boxes (this assumes there were no other inventory purchases in the month of December):
The cash basis P&L shows gross profit of $0 for the month of December, rather than the expected 40%. Obviously this isn’t correct. We need to remove the $3,000 from December COGS and put it on the balance sheet. We will then expense $100 of this box purchase beginning in January of 2020 as the boxes are actually shipped.
A proper accrual-based P&L would reflect the following if all inventory purchases were accounted for correctly:
Under the accrual basis we get an accurate gross profit. We have excluded the purchase of the $3,000 purchase of boxes from COGS by parking them on the balance sheet until they are actually shipped, and we have properly expensed only the actual inventory shipped in December.
The purchase of boxes is rather infrequent. So what about the purchase of the actual box contents? This requires more tracking. The most precise method is a monthly physical count as of the last day of the month. This way, if there is any excess inventory not shipped in the month, it can be properly reflected on the balance sheet and not on the P&L, which would artificially lower gross margin.
If you’d like assistance in tracking your inventory and calculating an accurate gross margin, you reach out to me via the contact form on the main page of www.boxedupbookkeeping.com, or email me at firstname.lastname@example.org.