How to Read a Financial Report: Wringing Vital Signs Out of the Numbers

Chapter 5. COST OF GOODS SOLD EXPENSE AND INVENTORY

Holding Products in Inventory Before They Are Sold

Please refer to Exhibit 5.1 at the start of the chapter. (Chapter 4 explains the design of this exhibit, which is also used in following chapters.) This chapter focuses on the connection between cost of goods sold expense in the income statement and the inventory asset in the balance sheet. Recall that the business in the example sells products, which are also called "goods" or "merchandise."

Cost of goods sold expense means just that—the cost of all products sold to customers during the year. The revenue from the sales is recorded in the sales revenue account, which is reported just above the cost of goods sold expense in the income statement (see Exhibit 5.1). Cost of goods sold expense is by far the largest expense in the company's income statement, being almost three times its selling, general, and administrative expenses for the year.

Putting cost of goods sold expense first, at the head of the expenses, is logical because it's the most direct and immediate cost of selling products. Please recall that this expense is deducted from sales revenue in income statements so that gross margin is reported there—see Exhibit 2.2 for an example of an income statement. Although gross margin is not shown on a separate line in Exhibit 5.1, in order to focus on the key connections of income statement and balance sheet accounts, I can't emphasize enough the importance of gross margin (also called ...