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# Costs We Actually Paid

When we raised the purchase order above, the system calculated the item's cost by looking at what a supplier's cost was made up of. Those components which were not included in the cost, for example freight, were still kept by the system, they just weren't shown to you. When the invoice is entered, you are given the opportunity to enter these costs as a lump sum and distribute them back against the invoiced items. This means that for each item we have the supplier's cost (consisting of the components provided by the supplier, for example Service Fee, Ullage, WET, GST) and the extra cost components (for example Freight). This means that we can add the cost components together and we would have the equivalent of the Landed Cost. This means that the cost we expected to pay, and from which we calculated our margins, can be directly compared to the cost we actually paid.

Now that we have finalised costs, the system can record these details to use as the cost of goods sold (COGS). The system has three costs that it can keep.

 Average Cost This is the most commonly used COGS method. The system takes an average of current stock value and the stock just received. The calculation is as follows: Avg Cost=(Current SOH * Current Avg Cost) + (Stock Received * Cost of Stock Received)/ (Current SOH + Stock Received) If you use this method it is very important that you try to enter the invoices as soon as stock is received. If you don't, the stock on hand may go negative which can cause the average cost to look strange. To prevent this, if the stock on hand drops below zero, the system does not calculate a new cost on hand but simply keeps the current value. Last Invoice Cost This is a very simple COGS method but it doesn't allow for the changes in cost that you have had over time. It simply records the cost from the last invoice you have accepted. Note, the cost used here DOES NOT INCLUDE freight. This is because when this COGS is used, freight is normally accounted for as an expense. First In/First Out This is a more complicated form of Average Cost and is used where you have a small number of large value items, for example electrical stores. It keeps track of every unit of stock and the cost paid for it. When you sell an item, you can use which specific item, and therefore cost, you are selling.

## Average Cost Considerations

Average Cost uses the following formula:

((Current Stock Qty x Current Avg Cost) + (New Stock Qty x New Cost))

/ (Current Stock Qty + New Stock Qty)

For example. We have 5 units at \$5 each and we receive 2 new units at \$6.

((5 x 5)+(2x6))/(5+2) = 5.29

This works well while we keep our stock on hand accurate and receive stock before we sell it. However, if the stock on hand is allowed to go negative, for example selling stock before entering the goods receipt or invoice, the average cost formula still works but it can have an interesting affect.

Let's say we have 5 units at \$5 each and we sell these units for \$8 (for sake of example assume all values are ex-tax). We have 20 new units coming in at \$6 each. However, we don't enter the receipt and sell 20 units. We will be selling the items at a cost of \$5 instead of the newer cost of \$6.

Lets have a look at the impact of this:

5 units at \$5 = Avg Cost \$5.

We sell 20 units at avg cost of \$5. We have a COGS of \$100. The SOH is now -15 with an average cost of \$5.

When we receive the 20 units at \$3, average cost is:

((-15 x \$5)+ (20 x \$6)) / (-15+20)= \$9

Hold on a second! I only paid \$6 for the item. Why is the system showing a loss now? Well, the formula is making up for the fact that you should have sold 15 of those units at \$6 each not \$5. You actually underestimated your COGS by \$15. It should have been 5 x \$5 + 15 x \$6 = \$115, not \$100. The average cost formula is just allowing for that lost value. You don't really have 5 units at \$6 each. You have to add the lost \$15 back in. Over 5 units that's \$3/unit, so the average cost is \$9 not \$6 and although you are going to make a loss on the next few items this is offset against the fact that you made more profit than you should have on those 15 items you sold.

Now, although that's technically accurate, it does get pretty confusing. The above example only shows a small loss. Depending on how many units you sell before you enter your receipts, you can see the average cost go up to very high numbers. And then people start asking why did we lose \$100 on that sale? The system doesn't work! What POS BE does is, if the stock on hand goes from negative to positive SOH, the average cost is simply set to the new cost. In this case, it would be set to \$6. This is much easier for most people to understand. If you sell another unit its cost will be \$6 and you are making a profit. Remember, POS BE is a merchandising system whose job is to give an indication of profit. It is not an accounting system, which is the only place you can truly measure your profit. However, POS BE can be used to provide interface data into an accounts system (see Accounts Interface). To work properly in this situation, POS BE will record that 'lost' value which can be used by the Accounts Interface Report. So, in the above case we had a lost value of \$15. POS BE will record that \$15 and extract that to the Cost Adjustment and Stock accounts in the accounts interface.