If your business is involved in the sale of merchandise, it is important that the cost of merchandise sold be "matched" with the revenue earned from the sale of this merchandise. Unless you report both revenue and cost amounts for a particular item of merchandise in the same month, income can be seriously distorted. If the revenue is reported in January, but the related cost of sales is reported in February, January income will be too high and February income will be too low. Also, the gross margin, which is the difference between sales revenue and cost of sales, will be incorrect. Your gross margin is an important monitor.
If your business is one in which you know the cost of individual items of merchandise, as with "big ticket" items such as automobiles, refrigerators, and personal computers, the matching process is easy. You record the cost of sales at the same time that you record the sales revenue.
If it is not practical to keep track of the cost of each item in your inventory, measuring cost of sales is more difficult. One possibility is to take an inventory at the end of the month. This inventory amount tells you the total dollar cost of goods on hand at that time. Then you can calculate the cost of sales by the process of deduction, because you know the inventory at the beginning of the month and the purchases during the month. The sum of these amounts is the total cost of the goods you had available for sale. You operate on the assumption that, if these goods were not in inventory at the end of the month, they were sold. You, therefore, find cost of sales by subtracting the ending inventory from the goods available for sale. You can also make allowance for pilferage, spoilage, or other causes of inventory shrinkage if it is significant. However, taking a physical inventory can be time-consuming. Many entities take inventory at the end of the year; few do it every month.
Another method of finding the cost of sales is called the retail method. You know the markup, that is, the percentage that you add to the cost of merchandise to arrive at the retail-selling price. Also, you may have at least an approximate idea of the markdowns from the normal retail price that you make during sales periods. You can use this information to arrive at an approximate cost of sales. If your cost of sales is normally 60 percent of your retail price, then your approximate dollar cost of sales is 60 percent of your sales revenue, adjusted for markdowns in months in which sales occur.
Several methods are available to make the adjusting entry for cost of sales. Often, the easiest is to debit Cost of Sales and credit Inventory for the estimated cost of the sales made during the month.
In a business that sells merchandise, the cost of sales is important; service entities do not have this problem.