Gross profit represents one measure of a company’s profitability. Analysts calculate the gross profit by subtracting the cost of goods sold from the total sales. Cost of goods sold is directly impacted by the inventory cost. Inventory of merchandising and manufacturing businesses usually represents one of the largest assets of these businesses. As a result, these businesses spend a significant amount of time analyzing their inventory levels and inventory cost.
Inventory takes different forms depending on the type of business. For a merchandising business, inventory represents the products purchased for the purpose of reselling to customers. Merchandise businesses receive the inventory, store it in the warehouse and then display it for customers to purchase. Manufacturing businesses hold three types of inventory. These businesses purchase raw material inventory to use in the production process. Warehouse personnel receive and store this inventory until the production department needs to use it. After the production department requests raw material inventory and begins working with the materials, it becomes work-in-process inventory. The product maintains this designation until the completion of the production process when the item moves into finished goods inventory.
Calculating Inventory Cost
The inventory cost affects both the ending inventory value on the balance sheet and the cost of goods sold on the income statement. A merchandising company calculates the inventory value by adding the purchase price and any freight charges. The company divides this total by the number of units to determine a cost per unit. A manufacturing company calculates the raw material inventory cost by adding the purchase price and the freight charges and dividing by the total number of units. Work-in-process inventory cost is calculated by adding the raw material cost with any labor costs incurred. Finished goods inventory cost combines the direct material cost, direct labor cost and allocates an amount for overhead.
Inventory Cost Reduction
Many companies strive to reduce their inventory costs. During times of rising prices, this allows them to maintain their current pricing levels to customers. Merchandising companies reduce inventory costs by taking advantage of supplier discounts and negotiating lower prices with the vendor. Manufacturing companies reduce inventory costs by negotiating lower raw material costs and reducing labor costs.
Gross Profit Impact
When companies reduce their inventory cost per unit, their ending inventory value decreases and the value of the cost of goods sold decreases. Companies calculate gross profit by subtracting the cost of goods sold from the net sales. Providing the selling prices remain the same, as the cost of goods sold decreases, the gross profit increases.