We launched the Primer in October, and we have dutifully written a Primer every week…until last week 😭😭😭
To atone for my sins, I wrote two this weekend! One comes out today (duh, you’re reading it), and the other is scheduled for Thursday—don’t get too antsy in anticipation.
Today’s Primer continues our journey into accounting by addressing the following question: how can I accurately track my product costs on each sale in Rundoo?
As always, a quick disclaimer: nothing we write is ever tax or legal advice! Please consult your accountant or attorney.
Average cost
Problem: what is your cost on each sale?
When you drop ship or do special orders, tracking the cost of each sale is easy. You bought product from a vendor, marked it up, and sold that very same product to a customer.
When you maintain inventory, on the other hand, tracking the cost of each sale is not straightforward. Costs will change over time, and your inventory needs to reflect those fluctuations.
Imagine you receive 10 units of a product at $5 each and 10 more at $6 each. Then, you sell one for $10. Was your cost on that sale $5 (50% gross margin)? $6 (40% gross margin)? Something else?
Solution: average cost
One standard practice that solves this problem is the average cost method. The average cost method says that the cost associated with each product sold is the average cost of your inventory of that product.
When you receive inventory, you update the average cost of the product based on what you paid the vendor. When you sell inventory, you associate the average cost of the product at the time of the sale.
I think this is best explained with an example, so let’s jump in.
An example: inflation frogs
Say we bring in a new product called Frog Tape.
We receive 11 rolls for $5.
Then, we sell one roll.
The cost on that sale was (obviously) $5, our revenue was $10, and we therefore made $5 in gross profit at a 50% margin. Woohoo! 🎉
Now, let’s say the manufacturer raised prices to $6, and we receive another 10 rolls.
The new average cost is ($6 * 10 new rolls + $5 * 10 remaining rolls) / 20 rolls, so $5.50.
Now, if we sell one roll, we associate it with the new average cost. The cost on that sale was $5.50, our revenue was $10, and we therefore made $4.50 in gross profit at a 45% margin. Across both sales, we now have made $20 in revenue, accrued $10.50 in costs, and made $9.50 in gross profit at a 48% margin.
FAQs
Is this the only way to do it?
Nope, but we think this most faithfully represents your cost at any time, and it is the main method we have seen our clients use. Two common alternatives, both of which require you to track the cost associated with each individual unit of a product, are:
First in, first out (FIFO): The cost on a sale is the cost of the oldest inventory received. Because prices generally increase, this method tends to result in lower costs, higher profits, and a greater tax burden.
Last in, first out (LIFO): The cost on a sale is the cost of the newest inventory received. Because prices generally increase, this method tends to result in higher costs, lower profits, and a lesser tax burden. Note that this method is currently banned by the International Financial Reporting Standards (IFRS) though accepted by the Generally Accepted Accounting Principles (GAAP).
What if my average costs are currently wrong?
The good news is that your average cost will trend to be correct as long as you receive inventory at the correct cost. That’s why it’s important to ensure costs on received orders are correct!
Note: you can still edit the cost of orders after they have been received. Rundoo will not retroactively change the cost on previous sales; instead, it will adjust the current average cost.
An upcoming Primer will explain how to match orders to payments.
What else?
Partial cents cost
Many vendors (such as Benjamin Moore and True Value) have products with a cost that is not full cents. In Rundoo, you can now store your costs on products to three or more decimal places. For example, our inflationary Frog Tape could become $6.295(!)
What next?
Average cost and partial cents cost are on for all clients right now. Check them out and let us know if you have any questions!
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