Welcome back. In our last lesson, we completed our overview of the income statement. Remember, the income statement helps us answer the third measurement question, how did you perform? As such, it represents a substitute attribute for the company's performance. Last time, we focused on the income statement line item revenue. In this lesson, our focus will be on the line that typically follows revenue, cost of goods sold. The concept of cost of goods sold isn't complicated. We can start by asking the question, what are goods? Goods are the assets either manufactured or purchased with the intent to be sold to customers. Let's visit the athletic apparel store, Body N Sole, in search of the goods. Here we are at Body N' Sole. You may remember Jed's store from an earlier lesson, and we're going to take another look around. Out on the floor of the store, we see the apparel. As we move to the back of the store, we see shelves of shoes, all of which Jed has purchased with the intent to sell them to customers. Well, ladies and gentlemen, these are goods. I know what you're thinking. Isn't this just the inventory we saw in an earlier lesson? Of course it is. When we think about cost of goods sold, we can also think about it as cost of inventory sold. Let's go back to the studio and dig a little deeper. We see now that there's a relationship between cost of goods sold and inventory. We can formalize this a bit by introducing the term total cost of goods available for sale. Where Jed's total cost of goods available for sale represents the cost of inventory that Jed held at the beginning of the period. We'll say the period began January 1st. Plus the cost of all the inventory Jed purchased and received during the period which ended December 31st. The maximum amount of inventory Jed could sell during the year is the inventory he started with and the inventory he added. Now at the end of the year, the cost of total goods available for sale is divided between two buckets. The cost of inventory that was sold during the year goes into the cost of goods sold bucket. While the cost of inventory that wasn't sold remains on the balance sheet as the cost of inventory. It's time to see what we've learned so far. Try these two questions and see how you do. With the conceptual understanding of cost of goods sold reported on the income statement, we're ready to introduce a little more complexity to the issue. Consider this scenario. Jed received several shipments of a popular model of athletic shoes throughout the year that he stores on shelves in the back room. Each time he receives a shipment of shoes, his cost to purchase the shoes increases. The first ship may cost $50 for each pair of shoes. The second shipment costs $60 per pair of shoes. The third shipment costs $65 for each pair of shoes and so on. Because all of the shoes look alike, when Jed sells a pair of shoes, he doesn't know if that pair came from the first shipment or the second shipment or the third shipment. So if Jed has 200 pairs of the popular shoe available for sale during the year, and he actually sells a 150 pairs of the shoes, what cost should he associate with the shoes that were sold? Fifty dollars, $60 dollars or $65? This question introduces the idea of cost flow assumptions. The three cost flow assumptions are first in-first out or FIFO, last in-first out, or LIFO, or average cost. If Jed adopts the first in-first out assumption, he's assuming that the shoes he purchased for $50 were the first shoes he sold to customers. If Jed adopts the last in-first out assumption, he assumes the $65 shoes were the first shoes he sold to customers. While using the average cost assumption, Jed calculates the weighted average cost for the pairs of shoes available for sale during the year, and assigns that cost to each pair of shoes actually sold. With respect to cost flow assumptions, there are two things you should remember. First, the cost flow assumption chosen can affect the cost of goods sold reported on the income statement. For example, if Jed adopts FIFO, his reported cost of goods sold will be lower than if he adopts LIFO. Second, the cost flow assumption that a company adopts need not match the physical flow of goods. Jed could very well sell the shoes he received first, but adopt the cost flow assumption other than first in-first out. Well, we've now tackled the first two line items on the income statement, revenue and costs of goods sold. What's unique about these two line items is that they're used to calculate an important summary amount. By subtracting the company's cost of goods sold from its revenue, we see the summary amount of gross profit. Gross profit is an important indicator of the company's performance and future prospects. If gross profit is large, it might suggest that the company is less at risk to small changes in the price of manufacturing or purchasing their inventory. Before closing out this lesson, I'll point out one final thing. The line item cost of goods sold is common in income statements, but you may see a slightly different name like cost of sales. Don't let that confuse you. Often the different label is related to the company being a service provider rather than a provider of goods. If a company sells dance lessons rather than athletic shoes, then there's little in the way of inventory, so cost of goods sold would be a less accurate characterization of a line item. We're not yet done with the income statement. As we move to the next module, we'll continue answering our measurement question about how the company perform, but we'll add a new twist to the conversation. Until then friends, be well.
