Income and Cost of Goods Sold
Yesterday, we mapped out expenses and created a plan for ourselves so our bookkeeping stays consistent. Today is about your income and cost of goods sold.
Let’s look at them individually.
Income (also known as sales or revenue) is the money we’re paid for the work we perform. This sounds like a pretty straightforward concept, but there are many grey areas.
We should be recording sales at the time they’re invoiced. In other words, when you create an invoice and send it to a client, your sale is recorded right then. Sometimes we get paid at the same time (a retail store is a good example of this), but sometimes we don’t.
If we get paid later, it’s important to know that cash received is not sales. This timing issue doesn’t usually matter, especially if we’re paid within the same month as the invoice, but it does matter when we invoice someone right at the end of the year or a quarter. We need to ensure the sale is in the right period.
Expenses are the same; they need to be recorded in the period in which they incurred. That means when you get your water bill, it needs to be recorded on that day and not on the day you paid it.
This is called the accrual accounting method. I recommend it over the cash accounting method because it gives a truer picture of the company at any given time. It keeps the income and expenses in the same period.
What happens if someone pays a deposit? When a deposit is paid, it needs to go into a liability account called Unearned Revenue. It’s not technically sales yet because the transaction isn’t complete. You still owe your client the work they paid you for. That’s why it goes into a liability account (we’ll talk about liabilities in a later lesson).
When the work is completed, then Unearned Revenue becomes earned and can be recorded as a sale.
Cost of Goods Sold
Cost of goods sold are the direct costs related to the sales we talked about above. They are attributable to specific jobs or sales and are used up in the course of that sale.
For example, if you built dollhouses, the wood used for the dollhouse would be the cost of goods sold.
It’s also the account that the cost of inventory goes into when it’s sold. If you owned a bubble gum store, the bubble gum you sold would be inventory. When you sell inventory, you need to reduce the inventory account and increase the cost of goods sold account.
Cost of goods sold is different than expenses because expenses are more general. They’re things like (if you’re a dollhouse maker) generic screws you keep on hand in case you need them. You didn’t buy them for any specific dollhouse, you just know you need them on occasion, so you keep them in the shop. These would be Supplies Expenses or whatever you decided makes sense for your business.
Taking total income and subtracting cost of goods sold gives you gross profit. Dividing gross profit by total income gives you the gross profit percentage. This is a tough number to increase and one to keep an eye on. You don’t want your gross profit percentage to start decreasing.
Income and cost of goods sold are the top two sections of your income statement. They’re important numbers to watch. We’ll talk more about income statements in a later lesson.
Task: Create an income statement in your accounting software (there should a Reports section where you can create one automatically). Don’t worry too much if you’re not up to date with your bookkeeping—use whatever dates you are caught up to. Look at the ratios we talked about today. How does your cost of goods sold compare to your gross revenue? If you look at a few years or months together, does it stay relatively flat or does it change quite a bit? Do you know what happened in the business to cause the difference?
Tomorrow, we’re going to get into details about expenses: how to tell if you should capitalize an expense, common expense accounts, and their uses.
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