Why Cost of Sales Can Go Wrong

It is typical in accounting software for the cost of sales to be assigned at the time the invoice by taking the fifo or oldest purchase or build cost of the item still in stock. This presumes that there is a legitimate item in inventory with a valid unit cost.

Where this can go wrong is when the item being sold is not in stock because the receipt of the item is delayed from being entered into inventory. The system then has to decide on a backup strategy to assign the cost of sale. It is either the last cost or possibly the average cost. It should be set in the system option for one or the other but not left as an arbitrary choice. Inconsistent profit reporting will result if the average or last cost is significantly different than the fifo cost.

What happens if this is the first time the item is being sold and there is no last or average cost?  (Its receipt has not been entered into the inventory on time.) In this case, the cost of sale will be recorded as zero. This will also result in a false sense of profit in the general ledger.

Procedure and discipline should be put into place to not allow an item to be invoiced if there is no quantity on hand or no assigned cost to it in inventory. This may require a bit of customization to the software. If you are using accounting software that does not allow modification, then you must be aware of this issue and not be surprised when it happens. You must also be prepared to have access to reporting that lets you find where zero cost of sales has been assigned as well as when the cost appears to be out of line with the expected cost of sales.

In some situations, the cost of an item may be irregular because it is an item built using a bill of materials. One of the components may not have a correct cost or be out of stock but the work order is still permitted to be generated. The production person may be aware that the raw material is available and ignores its status in the computer. Again, there must be a procedure and discipline to avoid this in order to maintain true inventory costs.

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