COST OF GOODS SOLD, 101What It IsWhere It Is &How You Figure It Out

Book Expo America 2005NEW YORK, NEW YORK

THE THREE BASIC FINANCIAL DOCUMENTS

BALANCE SHEET A financial snapshot of a company at a point in time.

SOURCES AND USES OF CASH (Cash Flow Statement) Shows how the cash was generated and was used, by breaking down the activities into operations, financing, and investment activities.

OPERATING STATEMENT The performance of a company over a designated period of time.

ABACUSABACUS is an initiative to create a benchmark for the measurement of independent bookstore operations.

To create the standard To measure against different business models To make available a measuring index for use in presentations to landlords and banks To help identify the variables for success

ABACUSThe numbers generated by the ABACUS study were used to create

THE 2% SOLUTIONConcentrates on Four Areas: Sales Margin Compensation OccupancyToday were focusing on margin

BUT TODAYS SESSION IS REALLY ABOUT COST OF GOODS SOLDTo make a plan to increase margin, you must first understand and know your Cost of Goods Sold.

DEFINITION OF COST OF GOODS

The total cost of everything you sold or offered for sale during the period.

GROSS MARGINCost of Goods subtracted from sales equals gross margin. Sales$400,000100%- Cost of Goods$240,000 60%= Gross Margin$160,000 40%

GROSS PROFIT SECTION OF AN OPERATING STATEMENTSales$400,000100%

Cost of Sales (COG Available for Sale)$284,000 Beginning Inventory (cost)$40,000 Purchase Expense$244,000

Less Ending Inventory (cost) $44,000

Cost of Goods Sold$240,00060%

Gross Profit$160,00040%In the Gross Profit section of an Operating Statement, we use a calculated Cost of Goods percentage to come up with the Gross Profit percentage.

GROSS PROFIT SECTION OF AN OPERATING STATEMENTSales$400,000100%

Cost of Sales (COG Available for Sale)$284,000 Beginning Inventory (cost)$40,000 Purchase Expense$244,000

Less Ending Inventory (cost) $44,000

Cost of Goods Sold$240,00060%

Gross Profit$160,00040%But in reality, we are coming up with a way to calculate the ending inventory at cost. We do that by using

RETAIL INVENTORY METHODA formula for calculating Cost of Goods that works extremely well for the retail book business.

RETAIL INVENTORY FORMULA

Beginning Inventory (cost) + Purchases--------------------------------------------------------= COG%Ending Inventory (retail) + Sales (retail)

RETAIL INVENTORY FORMULABeginning Inventory (cost)--------------------------------------------------------= COG%

Where does this number come from?

We find this number on the Balance Sheet of the previous years final financial statement.

RETAIL INVENTORY FORMULA

+ Purchases---------------------------------------------------= COG%

Purchase expense is the only number in the Retail Inventory Formula that requires a calculation. The other three variables are either actually counted or exist on the year-end Balance Sheet.Purchase expense equals what you spent on merchandise for sale (+) or (-) the difference in accounts payable from the beginning of the period to the end.

PURCHASE EXPENSE CALCULATIONChecks written for merchandise for sale during the period, plus the difference between accounts payable at the beginning of the period and accounts payable at the end of the period, equals purchases:

Checks= $50,000

Accounts Payable (opening)= $20,000 Accounts Payable (ending)= $10,000Difference=-$10,000

Purchases= $40,000

PURCHASE EXPENSE CALCULATIONHeres another example:

Checks=Accounts Payable (opening)=Accounts Payable (ending)=Difference=

Purchases=$46,000$15,000$19,000$ 4,000

$50,000

RETAIL INVENTORY FORMULA

--------------------------------------------------------= COG%Ending Inventory (retail)

This must be based on an actual count of the merchandise for sale at the end of the last day of the fiscal year. The count is done at the price at which the goods are being offered for sale at that point in time.

COUNTING INVENTORYThere are two ways to count inventory:

Annual count On the last day of your fiscal year, physically count every book in the store.Incremental counts each month count a few sections, totaling those counts at the end of the yearThese are also known as:

The right way actual countThe wrong way incremental count

COUNTING INVENTORYIncremental counts of inventory are helpful in tracking inventory throughout the year, but they cannot be used for obtaining an accurate count of the inventory to be used in calculating your cost of goods.Without doing a physical count of your full inventory at least once a year, inaccuracies will mount, and the discrepancy between your inventory and your payables will grow exponentially. You must reset the clock each and every year.

CLEAN CUT-OFFSEverything must be counted only once, whether its a book, a dollar, or a chargeback. Over- or undercounts go directly to your bottom line. For this reason, its crucial to have clean cut-offs.The Building BlocksBookDollarChargeback

RETAIL INVENTORY FORMULA

------------------------------------------------------ = COG%+ Sales (retail)

This is a total of all sales of all merchandise during the period.

Basically, this is a Z tape for the year.

RETAIL INVENTORY FORMULA

Beginning Inventory (cost) + Purchases--------------------------------------------------------= COG%Ending Inventory (retail) + Sales (retail)

Now lets put some numbers in the formula

RETAIL INVENTORY FORMULA

Beginning Inventory (cost) + Purchases$40,000$244,000--------------------------------------------------------= COG%$73,000$400,000Ending Inventory (retail) + Sales (retail)

RETAIL INVENTORY FORMULA

Beginning Inventory (cost) + Purchases$40,000$244,000 = $284,000--------------------------------------------------------------------- = COG% = $473,000$73,000$400,000Ending Inventory (retail) + Sales (retail)

RETAIL INVENTORY FORMULA

Beginning Inventory (cost) + Purchases$284,000--------------------------------------------------------= .6004 $473,000Ending Inventory (retail) + Sales (retail)

COG% = 60%

GROSS PROFIT SECTION OF AN OPERATING STATEMENTSales$400,000100%

Cost of Sales (COG Available for Sale)$284,000 Beginning Inventory (cost) $40,000 Purchase Expense$244,000

Less Ending Inventory (cost)?

Cost of Good Sold$240,00060%

Gross Profit$160,00040%

Now we can solve for this

RETAIL INVENTORY FORMULABeginning Inventory (cost) + Purchases$40,000$244,000--------------------------------------------------------= .6004 (COG%)$73,000$400,000Ending Inventory (retail) + Sales (retail)

Physically counted ending inventory atretailXCalculatedCOG%=$73,000 x .6004= $43,829

Ending inventoryat cost

GROSS PROFIT SECTION OF AN OPERATING STATEMENTSales$400,000100%

Cost of Sales (COG Available for Sale)$284,000 Beginning Inventory (cost) $40,000 Purchase Expense$244,000

Less Ending Inventory (cost) $43,829

Cost of Good Sold$240,17160%

Gross Profit$159,82940%

Wasnt that easy?????

RETAIL INVENTORY FORMULAOKSo this is not a perfect world.

There are a couple of small weaknesses to this method:

Discounts given are netted into salesShrinkage (theft) is netted into ending inventory at retail

RETAIL INVENTORY FORMULAAnd to do this right, there are a couple of unbreakable rules that apply:

Clean Cut-OffsMiscalculations, dollar for dollar, go to the bottom line

Actual Counts of:Inventory Payables (including chargebacks)

SO WHY IS THIS ALL SO IMPORTANT?There is no way to measure the results of your operations without an accurate calculation of Cost of Goods Sold.You cant make a plan to increase margin without first understanding and knowing your COGS.You may think you know if you are profitable using historical numbersBUT, YOU DONT!

THE DREAM SCENARIOIf we could get all independent booksellers to accurately calculate their Cost of Goods, thereby greatly increasing the number of stores with very accurate financial statements, and then get all of those stores to report all of those accurate numbers to the ABACUS Survey, what wonderful educational tools we could develop. --Anonymous Domnitz

BUT FOR NOW

Lets all commit ourselves to creating an accurate set of financial documents, laying a foundation on which we can build stronger, more profitable bookshops moving forward.

THANK YOU FOR LISTENING

THE BEGINNING

Seminar is designed for those who dont currently have a good grasp of Cost of Goods, which, experience has taught us, includes a lot of people who think they grasp it. Were going to look at what COG is, where in your financial documents you find it, how you calculate it, and why its important.Not going to be able to fill Avins shoesThis first slide is showing what this presentation is NOT about.But you need at least a cursory understanding of these documents to understand COG and important metricsAny financial statement will have these three documentsThe least familiar to most people is the Sources and Uses of Cash. It shows how your cash is used in three different ways Operations, Investing, Financing. ABA produced an ABACUS study every year until 1997. The reason we stopped was lack of participation, and that was a shame. It is critical, especially in highly competitive times such as these, that we have benchmarks.We revised the survey to make it much, much easier to participate, and participation has gone up, but its still not where it needs to be.Weve extended the deadline this year to June, hopefully allowing more stores to participateYour numbers are only every seen by one person at ABA, and thats Avin. The rest of us dont even know if youve participated. So Ill ask who here has participated?If youve never seen Avin present the 2% solution, make you sure do at BEA this year. The basic idea is this. The average ABACUS reporting store is showing a 1.7% loss. By making modest changes to your sales, your margin, you payroll, and your rent/occupancy costs, you can move from a loss to a 2% profit.Todays seminar deals with the second item on this list: Margin. If you can increase your margin 1%, you can increase your bottom line profit by more than 1%. One thing repeated over and over again in the 2 % solution is that you need to have well thought-out, concrete plans to move toward profitability. Before you have a plan to increase margin, you have to know and understand COGS. This is the relation between COGS and Margin.The mythical store were going to use in our examples today is a $400,000/year business. Youll need the Ending Inventory at Cost to fill out the Gross Profit section of your operating statement. Like so much of the content in educational seminars, we are not showing you anything new. This is a pretty standard accounting practice. The concept behind this formula is very simple -- Everything you owned a t the beginning of the year, plus everything you bought, divided by everything you own at the end of year, plus everything you sold. Walk through this one slowly.

If you have more payables at the beginning of the year than at the end, your total purchases are lower. If you have fewer payables to start, your purchases are higher. And it must be accurate. The inventory should only include those items for which you have a payable document or a check. Its critical to avoid double counting, or under counting merchandise.More on these two ideas laterStores using outside services should do verifying counts when theres more than a 2 % discrepancy. Also note that this count is net of discounts. If you sell a $20 Book Sense Bestseller for for $18, you count the book at $18. Again, this is everything you owned a t the beginning of the year, plus everything you bought, divided by everything you own at the end of year, plus everything you sold. Pause for questions. Having clean cut-offs is the key to success with this method. This means that one year is one year in terms of the numbers. Think of the units were using in these formulas as building blocks. The building blocks either come in the form of books, dollars, or chargebacks. Every dollar has to be accounted for by one of those building blocks.If you have a book in your inventory, but dont have a corresponding payable, youll have over-counted your inventory. Imagine you get a new Barbara Kingsolver book the day before you count your inventory, in other words, a day before the end of your year. Of course you want to put the books out, so you do. You count the books, but you dont yet have the invoice, and you close your year, and use this nifty formula to calculate your COGS. But its going to be wrong. You need to make sure you have the payable documents included in your numbers. Look at what it says here: dollar for dollar, mistakes go to the bottom line. If youre your inventory count is off by $400, thats $400 to your bottom line in either direction.If you can increase margin 1%, you can grow your bottom line 1.13%. In a $400,000/year store, thats $4,520. I dont know who first said this, but if you cant measure it, you cant manage it. Conversely, if you cant manage it, dont bother measuring it.

Questions?