As the tax return deadline approaches, businesses are faced with a major challenge: They not only need to communicate their tax returns to the HMRC, but also their previous year’s profits. Small businesses, self-employed individuals, and freelancers need to take the cash inflow and outflow principle into account when calculating their profit. But what exactly does this mean? This guide will help...
Any company that is required to carry out double-entry bookkeeping has to submit not just one balance sheet, but also a profit and loss report to the HMRC. While the balance sheet provides a precise overview of what comprises a company’s assets and liabilities, the profit and loss report represents expenditure and income.
In the UK, companies operate according to the Financial Reporting Standard 102. When it comes to valuing inventory or stock, FRS allows a company to choose whether they want the weighted-average cost method, the First-In, First-Out (FIFO) method or the specific identification method. Depending on the method you choose, the outcome could be very different; for example, using the weighted average method could result in a lower stock valuation.
It is also worth noting that most other countries run their business using the International Financial Reporting Standards (IFRS). The FRS 102 is based on the IFRS. The International Financial Reporting Standards (IFRS) prohibit the use of the Last In, First Out (LIFO) method which is still in use in the US, but is considered rather controversial. If you are running an international company with offices in the US, it may be worth keeping this in mind since your accounting methods will likely vary by country and not always be compatible with one another. In that case, it is recommended to use IFRS for the sake of comparability.
- How the weighted-average cost method works
- How the first-in, first-out (FIFO) method works
- How the specific identification method works
- Why is calculating cost-of-sales important?
- Disadvantages of using a cost of sales method
How the weighted-average cost method works
This method applies a cost to all inventory items based on the entire cost of goods purchased or produced in each time period, divided by the entire number of goods purchased or produced. Put simply, the weighted-average cost method uses a simplified average for all similar goods in inventory, no matter when they were purchased, as well as a tally of all final inventory goods during a given accounting period. By multiplying the average cost per item by the final inventory tally figure, the company works out a sum for the cost of items available for sale at that time. The same average cost can then also be used with the number of goods sold in the previous accounting period to discern the cost of goods sold (COGS).
Advantages and disadvantages of the weighted-average cost method
The weighted-average cost method requires very little effort to undertake and is, therefore, the least expensive of the three available methods. As well as how simple it is to apply the average-weighted cost method, it is more difficult to manipulate income than with other methods. The average-weighted cost method is particularly beneficial to companies that produce almost-identical goods, or companies that find it hard to work out the cost of individual items, as well as when there are vast quantities of similar items passing through an inventory, making it time-intensive and laborious to track each individual item. Since the weighted-average cost method is based on average numbers, this means that the costs assigned to production are not actually the exact costs, and that materials being used in the production of goods may not be charged at the accurate price.
How the first-in, first-out (FIFO) method works
The First-In, First-Out (FIFO) method helps value and manage assets by selling, using and disposing of the first assets produced or acquired before the others. Concerning taxation, FIFO holds that inventory with the oldest costs are included in the income statement’s COGS. After that, the leftover inventory items are matched to the most recently bought or produced assets. This results in the monetary value of the total inventory decreasing due to inventory no longer being in the company’s possession. Put simply, FIFO stipulates that items bought or obtained first are disposed of first, and that the last items remaining are those bought or obtained last.
Advantages and disadvantages of FIFO
There are several advantages associated with utilising the FIFO method. FIFO is a widely used and accepted method of inventory valuation and is a relatively simple concept to grasp – managers do not need specialist accounting training to use the FIFO method. FIFO makes manipulating the stock valuation with income declared in financial statements much more difficult since there are set values to be used in the cost of sales calculations in the income statement. However, despite FIFO being an easy-to-understand cost of sales method, much data collection is required which can result in additional errors. There are also disadvantages to using FIFO if the goods you are valuing fluctuate often in price, or if your country is experiencing fluctuating inflation. When monetary values fluctuate with inflation, so too do the cost of goods which can result in misstated profits.
How the specific identification method works
As the name suggests, the specific identification method works by keeping track of each individual item of inventory. In comparison to FIFO where inventory is grouped, specific identification requires managers to keep track of every single item in the inventory from the date of purchase to the time of sale. Because this method is much more cumbersome, it is most often applied to larger items such as vehicles or furniture as these can have widely varying price tags.
Advantages and disadvantages of specific identification
The primary advantage of using specific identification is that it can help a company account for inventory and sales volume much more accurately. This could help save on taxes by making more accurate accounting predictions regarding revenue and costs. It is a very precise way of keeping book of the cost of inventory. However, in practice, the method is rarely used because it requires clear identification of the goods purchases and sold. That is feasible for large items, but quickly becomes a burden on the accountant when dealing with large inventory quantities. Critics also argue that the method allows management to manipulate ending inventory costs more easily.
Why is calculating cost-of-sales important?
A decisive advantage of using a cost-of-sales process is finding out the gross profit. Since calculating the cost-of-sales only considers revenues and costs related to sale, it provides a reliable indication of a company’s market success and profitability. Knowing the cost of goods sold helps analysts, investors, and managers estimate the company's bottom line. If COGS increases, net income will decrease. A prudent company will try to keep COGS line with yearly budget forecasts.
Grouping the process into collective areas like sales, production and administration often correspond to structures within large companies. In this way, figures can be used as a basis for management’s decision-making, since they clearly show financial strengths and weaknesses in each area and can help to make more informed decisions about what measures may need to be taken to reduce costs.
Cost-of-sales procedures can be applied to individual product groups, sales areas or distribution channels. It provides the company with comparable results to show whether a product range is performing well on the market or whether individual product lines or sales strategies are unprofitable and should be abandoned.
The income statement should be internationally comparable, if the countries adhere to similar accounting principles.
Disadvantages of using a cost of sales method
A major disadvantage of the process is the amount of effort required. The figures cannot be derived from double-entry accounting, instead, they must be calculated from cost accounting and statistical calculations. This is particularly problematic for small and medium-sized enterprises since they rarely carry out separate cost accounting in addition to their regular bookkeeping.
Cost of sales procedures often raise questions of when and why an asset is valued since operating expenses must be clearly assigned to functional areas (e.g. manufacturing, administration, distribution), which is not always easy. The allocation affects the number of expenses in each area. In addition, the decision regarding allocation should be adhered to throughout subsequent years to ensure consistency.
Please note the legal disclaimer relating to this article.