Happy Tuesday. Today I am having lunch with Delena Meyer of Way Enough Decision Coaching. I was fortunate enough to work with her at my last Company where we had to work through some growing pains. For an Organization facing pressures (aren’t we all) it is worth bringing in an outside consultant to bring a different viewpoint and work with the management team to find ways to move forward together. I will have more to write about Way Enough Decision Coaching tomorrow but I strongly recommend her if you want a coach who can cut to the chase. Her number is 360.281.4743. Give her a call and let her know you were referred by John.
Cost of Goods Sold
Inventory is typically the largest dollar value of current assets in many small businesses. This is especially true in retail, wholesale, construction and manufacturing. When goods are sold, the dollar value of the items is adjusted from inventory to cost of goods sold (CoGS). Which by the way, typically means that cost of goods sold is the largest “expense” item on the Income Statement.
I can hear my editor now, “John, if it is such an important number, why aren’t you tracking it on the Dashboard?”
The answer is, of course, that we are tracking it – using the amount in Accounts Payable as a reasonable substitute. The goods in a business are almost universally purchased on terms so a healthy business will typically have inventory approximately equal to the amounts owed vendors.
I will spend more time on inventory in a later blog post, but the big take-away for today is that CoGS represents a significant item and it is the largest opportunity for error and irregularity in small business.
A Client Story on CoGS
About 2009, the firm had a client, ABC (named changed to protect the innocent) which was a specialty manufacturer. The Company had borrowed a substantial amount of money from the Bank and had also bought out a major shareholder and owed on a term note. The Bank required ABC to have a reviewed financial statement. The information below is what the financial statements reported each year.
| 2005 | 2006 | 2007 | |
| Inventory | |||
| Raw Material | 5,000,000 | 5,500,000 | 5,200,000 |
| WiP | 2,000,000 | 1,800,000 | 1,600,000 |
| Finished Goods | 1,000,000 | 1,300,000 | 1,000,000 |
| Total Inventory | 8,000,000 | 8,600,000 | 7,800,000 |
| Revenues | 18,000,000 | 19,500,000 | 20,500,000 |
| CoGS | 14,000,000 | 15,400,000 | 16,500,000 |
| Gross Profit | 4,000,000 | 4,100,000 | 4,000,000 |
| Profit Margin | 22.2% | 21.0% | 19.5% |
| Net Profit | (2,500,000) | (2,750,000) | (1,500,000) |
The 2008 Surprise Change to Cost of Goods
The client sent over their internal financial statements and trial balance in February 2009 showing the following information:
| 2007 | 2008 | |
| Inventory | ||
| Raw Material | 5,200,000 | 6,000,000 |
| WiP | 1,600,000 | 1,750,000 |
| Finished Goods | 1,000,000 | 1,250,000 |
| Total Inventory | 7,800,000 | 9,000,000 |
| Revenues | 20,500,000 | 21,000,000 |
| CoGS | 16,500,000 | 14,500,000 |
| Gross Profit | 4,000,000 | 6,500,000 |
| Profit Margin | 19.5% | 31.0% |
| Net Profit | (1,500,000) | 1,250,000 |
The first thing the staff noticed was that CoGS dropped by $2,000,000. When you look a little deeper, you realize that inventory increased by $1,200,000. For the professional, this looks a little suspicious so we started digging. By asking the following questions (and others) we discovered the truth.
- How can sales remain flat while CoGS drops by 12%? Is there a new customer willing to pay a hefty premium?
- Did ABC stop what it was doing at the end of the year and physically count the inventory? Who reviewed the count sheets?
- What are 2009 sales projections for ABC? Given that we are in a tight credit situation, will sales grow in excess of 20% over 2008 to justify the investment in inventory?
The answers we received sadly required the firm to withdraw from the engagement. But the point of the story is that as a small business, you should ensure your management team is on top of things like Cost of Goods Sold. The balance is potentially large, there are huge dollar amounts flowing through the account and a small change in the margins can impact your profitability – and potentially your banking relationship.
My recommendations for staying on top of your CoGS:
- Require a full physical inventory count at year-end. No matter how good your accounting system, a physical count helps keep the computerized data synced.
- Review your gross profit margin monthly. If you are averaging 40% gross profit and it suddenly dips to 30% for no reason, ask questions. It may be legitimate, it could be a posting error, or it could be something like fraud.
- Go out and spot count a few high dollar inventory items and compare your count to the accounting system. You doing it yourself will show your team how important you think inventory and CoGS is to your business.
- Don’t try to hide a business problem by adjusting your CoGS. In the story, the business had to show a reasonable profit margin in 2008 or the bank was going to place ABC in Special Assets. ABC still ended up in Special Assets. Also, the CFO was terminated, shareholder/manager compensation was reduced by 80% and the business could no longer pay the notes to the retired shareholders. 4 years later the Company was liquidated for about $0.15 cents on the dollar. A few years later I ran into the banker and he said that the Bank may have been willing to work things out with ABC had they not tried to fool them. Sad.
If your business sells goods, your CoGS plays an important part of your profitability. It is intimately tied to your inventory levels and can be challenging to stay on top of. Knowing how CoGS is related to your revenues and feeds out of your inventory can help you grow profitably and with fewer headaches. Talk with your accounting professional if you have questions or feel free to send me an email if you would like to discuss this article or anything else regarding your business.
Have a great day.
Accounting Clarity 