The cost of sales 1/2

The term Cost of Sales is one of those accounting terms that is common language for some but for most makes you want to curl up in a little ball and suck your thumb while rocking yourself gently for comfort. It really can be a nightmare to try and manage.

It has been my experience that many owners from within the salon industry couldn’t be bothered with cost of sales and the implications thereof. They see it more as a random requirement for their accountants. On the other hand salon owners who perhaps come from outside of the hair industry (like manufacturing or big retailing) are obsessed with cost of sales almost to the detriment of other areas of their salon business.

I think that owners from “big” business are used to dealing in very fine margins and if these margins are not controlled correctly the consequences can be extremely damaging to their bottom line.

What is Cost of Sales?

Well, the name really says it all. How much did it cost you (in stock terms) to do the sales that you did in a particular period? It so simple isn’t it? We’ll see…

Let’s say you sell a bottle of shampoo for R200 and this bottle had originally cost you R100, then the cost of selling this bottle was R100. The difference between these two is known as Gross Profit.

That is why when you look at your Income Statement you will see a section that shows you Sales at the top. Then below the Sales you will see a Cost of Sales section and then you will see the Gross Profit. Then after the Gross Profit you will see all your expenses listed and then finally you will see your Net Profit, which is what you pay Income Tax on.  Therefore: (Sales – Cost of Sales = Gross Profit) – Expenses = Net Profit

(Note that some argue in favour of treating Sales Commission as cost of sales because they determine that they need to pay this commission in order to generate the sales but for this article I am only looking at stock usage for the purpose of cost of sales).

Purchases and Cost of Sales

What is probably common for many salons is to simply treat their Purchases as Cost of Sales, which is not technically correct. What this means is that if you purchase R20000 stock in a month then you allocate this entire value to your cost of sales, whether you actually sold it all or not.

Let’s say that you mark up your stock by 100% and you sold all of the abovementioned stock for R40000 then your sales would be R40000 and your cost of sales would be R20000 and your gross profit would be R20000.

That’s great as long as you always sell all of the stock that you buy within the same period. However, if you only sold a quarter of the stock you had purchased, ie for R10000 and you still allocated the entire purchased value to cost of sales then your gross profit for the period would be( –R10000), which is obviously incorrect. Therefore, you would need to actually calculate the cost of only what was sold, ie R5000 so that you could reflect the correct gross profit of R5000. But this leaves us a problem then of what to do with the remaining value of stock purchased for the month as we can’t allocate it as an expense. You therefore need some way to hold the value of the remaining stock.

Stock on hand

Stock on hand is actually an asset in your business. It only becomes an expense when you sell it. For example, if you want to sell your business you will include all the stock on the shelves and in the stock room as assets in the calculation of the value of your business i.e. they will appear on your balance sheet. If they had been written off as expenses when you first purchased them they would not hold any “book” value in the sale of your business.

When you sell the stock you will decrease the Asset (Stock) and then raise the Expense (Cost of Sales) because the stock has actually gone out of the business and was used to generate income.  Are you still with me or are your eyes beginning to glaze over?

To keep it simple I always remind myself that as a rule of thumb when I spend money on an Asset I always have something tangible to show for it, ie stock, furniture, equipment etc. When I spend money on an expense I don’t have anything tangible, ie phone, electricity, salaries etc. That is why when you buy stock you have something tangible (ie stock on the shelf), until you have sold it again (not on the shelf anymore) and then it is an expense.  You expense it in the same period that it was used to generate income.

Retail vs Professional Stock

Hair Salons have an extra dimension to the cost of sales debacle in that they work with both Retail stock and Professional stock. Retail stock is “relatively” straight forward in that you buy an item and you sell an item, with the main challenge lying in the fact that you buy the stock at different prices from the supplier over time.

However, for professional stock it is a little more complicated. What I am referring to here is the stock used in doing services for clients, ie the shampoo used at the basin or the colour formulas used. The difficulty is that these costs vary from client to client and are measured out in millilitres.

This is why salon owners generally allocate a flat fee or percentage against all services done, which they often deduct from stylist turnover before commission because having to measure out stock used and track it per millilitre is too daunting a task.

Therefore the measuring of professional stock usage poses a problem in the calculating of cost of sales because you need to track what you use in order to do so and it is important to understand the cost of sales for Retail separately from the cost of sales for Services (Professional Stock).

Stock used

The general formula for cost of sales is as follows: Opening Stock + Purchases – Closing Stock = Cost of Sales. This means that you start the month by counting all the stock in the salon. Then you add to this value any purchases you made during the month. Then at the end of the month you count you have left and the difference is what was used in the month. The only problem is that you are not certain whether the difference is made up on pure usage or whether there was theft or other reasons that reduced your stock holding.

Therefore you ideally need a way to track what stock “should” have been used to determine if your cost of sales is accurate or whether there is a variance that is unusual.

Conclusion

As you can see Cost of Sales can be extremely complicated. In next month’s article we will take a look at some of the procedures including stock takes, valuation methods and other cost of sales reporting elements.