Businesses vary greatly in terms of the types of goods and services they provide to consumers and how they produce and deliver those goods and services, but every business has the basic goal of making a profit. Notably, the cost of goods sold is the sum of different costs that are incurred in the product and selling processes of products of an organization. Bookkeeping principles have been defined for recording and summarizing the gross profits and cost of goods sold.
Factors Affecting Gross Profit
Cost of goods (COGS) sold is one of the key elements that influences the gross profit of an organization. The cost of goods sold for a particular service or product refers to the direct costs that are associated with its production, which includes labor necessary to produce the product and materials for the product. Hence, an increase in the cost of goods sold can decrease the gross profit. Since the gross profit comes after the reduction of variable costs from the total revenue, increases in the variable costs can decrease the margin for gross profit. Hence, the greater the cost, the lesser the gross profit.
In addition, cost of goods sold does not include indirect costs that cannot be attributed to the production of a specific product, like advertising and shipping costs. Similarly, it means that the higher the COGS, the lower the gross profit margin. If the COGS exceeds total sales, a company will have a negative gross profit, meaning it is losing money over time and also has a negative gross profit margin.
Calculating the gross profit margin requires calculating gross profit. According to the IRS, gross profit is equal to total receipts or sales minus the value of returned goods and the cost of goods sold. Gross profit margin is equal to gross profit divided by total sales and is often expressed as a percentage. For example, if a company has a gross profit of $500,000 and $1,000,000 in total sales, its gross profit margin is 1/2 or 50%. This means that, for every sales dollar the company takes in, it earns 50 cents of profit.
Total sales or gross receipts is the other key component of gross profit margin. When sales exceed costs by a large amount, gross profit margin will tend to be high, while low sales will tend to result in a low gross profit margin or negative profit. Any factors that can increase sales such as lower tax rates, higher consumer confidence, and effective marketing campaigns can also result in a higher gross profit margin.
Factors Affecting the Cost of Goods Sold
Different factors contribute towards the change in the cost of goods sold. This includes the prices of raw materials, maintenance costs, transportation costs and the regularity of sales or business operations. Meanwhile, inventory as valued plays a considerable in the calculation of the cost of goods sold of an organization. The two most common methodologies for inventory valuation include Last-In-First-Out (LIFO) and First-In-First-Out (FIFO). FIFO carries an assumption that the goods produced first are sold first. This means that, when a firm sells its good, expenses related to the production of the first item are considered.
On the other hand, LIFO carries an assumption that the latest produced goods are the goods that are sold first, whereas, the expense involved in the manufacturing of the last item recognized. Consequently, objects manufactured later are commonly more expensive because they require the materials and labor costs that are in accordance with the existing prices. Thus, LIFO has the tendency to increase the cost of goods sold, which leads to a decrease in income for both reporting and tax purposes. Hence, it can be said that cost of goods is affected by the method through which it is recorded and the changes in the prices of materials and labor costs involved in the production and sales.
In addition to the above, a company can have a lower gross profit compared to another similar company, but still have a higher profit margin. For example, a small company might only have sales of $50,000, but if its cost of goods sold is $25,000, it has a gross profit margin of 50% and $25,000 of gross profit. A large company might have $1,000,000 of sales and $900,000 in costs, which amounts to a gross profit margin of 10% and $100,000 of gross profit.
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