If you are using QuickBooks to manage your inventory, you need to understand how QuickBooks deals with the cost of inventory items. Unfortunately, the term “cost” is used in several different ways, and it can get confusing. Here is a quick rundown of how QuickBooks handles things.
I’ll focus on Inventory Part items, which are the true “inventory” items in QuickBooks, with a little detour to talk about Inventory Assembly items.
Cost Fields in QuickBooks
If you look at an Inventory Part item, you will see that there are two cost fields.
Cost, on the left, is a “reference” field. That is, it doesn’t have any direct bearing on the valuation of your inventory, the cost of your inventory in your inventory asset account. I wish they had another name, because it is confusing to talk about it. I refer to this as the “last purchased cost”, although that isn’t always exactly right.
If you purchase an item and receive a bill for it, the cost that you receive the item at will usually be stored here (but not always, that depends on how your company file is set up). You can edit this cost directly in this window. This does not have a direct effect on your inventory valuation.
The avg cost field, bottom center, is the field that is used in the calculation of the value of your inventory. This is calculated by QuickBooks based on the cost of receipt (and adjustment) transactions. You cannot directly edit this in this window.
If you look at the edit item window for an Inventory Assembly item you will see a third cost, the total bill of materials cost, which is another “reference” cost (not directly affecting inventory valuation). I’ll discuss that in more detail later.
Inventory Valuation
QuickBooks values your inventory using an average costing calculation, as opposed to other types you may be familiar with, such as LIFO, FIFO, or specific costing. This can be a complicated subject – I am only going to go into this lightly. Let’s look at a simple example.
- If start with an item with no quantity, no value, and receive a quantity of 10 at $1.00 each
- 10 items and a value of $10.00, we added another 10 items at a value of $20.00, so, you will see that the cost is $1.00, and the avg cost is also $1.00. You have $10.00 of inventory in your inventory asset account.
- If I then receive another 10 items, but at a unit cost of $2.00, you will usually see the cost value set to be $2.00. However, the avg cost of your inventory will show as $1.50. We started with we have 20 items with a value of $30.00. That gives us an average cost of $1.50.
If you sell one of these items in an invoice, the Cost of Goods Sold (COGS) account is incremented by the average cost of the item at the time of the sale.
One thing that I will note, briefly – if you sell all of your inventory, and then continue to sell the item so that you go to a negative quantity, the costing calculation runs into problems. QuickBooks can’t accurately account for a negative balance, and you can see some very odd figures show up in the average cost field, and your inventory valuation reports. Once you bring the balances back to positive these figures should resolve themselves, but it is always a good idea to not allow inventory balances to go negative.
Editing the cost field in an inventory record will have no bearing on the avg cost, or your inventory valuation. The only way to directly change the avg cost or valuation is to use the inventory adjustment function and do a “value” adjustment.
Manufacturing Cost
Let’s take a look at an inventory assembly item. The WHAS wheel assembly has two components, a screw (two of them) and a roller. Note that there are three costs shown in this window.
The Cost field (15.00) has no real bearing on valuation of this item as I have discussed above.
The Avg Cost field (32.00) is the cost that QuickBooks uses to calculate the value of this item.
The Total Bill of Materials Cost field (32.00) is not directly tied to the cost or avg cost values. This is the sum of the cost values of the components in the BOM. In our starting example it matches the avg cost, but they are not connected.
If I build this assembly item, the avg cost of the assembly will NOT be adjusted by this total bill of materials cost. Instead, QuickBooks will take the avg cost of the component items and roll that into the received cost of the assembly. You can’t look at this screen and tell what the exact cost of the build will be. Remember, the total bill of materials cost shown here is based on the cost field of the components, not the avg cost value. But avg cost is what is used in valuation.
For a more detailed explanation of costs in inventory assembly items, see my article on Understanding Total Bill of Materials Cost in QuickBooks.
QuickBooks Pro & Premier 2011 and Enterprise Solutions 11.0 offer new and improved Purchase Order Reporting.
The Open Purchase Orders Detail report is new in QuickBooks 2011 versions (Pro, Premier and Enterprise 11.0). As the name implies, the report displays items (cost codes) that haven’t been received in full.
I’m excited to see that after many years, Intuit has finally fixed the Purchase Order reports to ACCURATELY display open balances, without a lot of additional manipulation by the user.
To find the new report, from the Report menu in QuickBooks Pro and Premier 2011 and Enterprise 11.0 -> Purchases -> Open Purchase Order Detail.
Right click on the image to enlarge it.
This report lists Purchase Orders by Items or Cost Codes that haven’t been received in full. By default, QuickBooks displays the following information for each Item or Cost Code:
- Date – the date of issue
- Num – the Number
- Name – the Customer and/or Job that the item ordered is for
- Source Name – the Vendor or Subcontractor who you placed the order with
- Memo – the Item or Cost Code description used
- Delivery Date – if you utilize the Delivery Date field on the form, the delivery date you entered will display
- Qty – the original Quantity, Units, or Hours that was ordered
- Rcv’d – what portion of the original quantity ordered has been received
- Backordered – what portion of the original quantity ordered has not yet been received
- Amount – the original dollar value
- Open Balance – the dollar value that has yet to be received
Right click on the image to enlarge it.
QuickBooks groups the same items/cost codes together.
Right click on the image to enlarge it.
Personally, I would change the way the report displayed information. Rather than to display the information based on Items or Cost Codes, I would like the information to be grouped by Customer and then by individual Job. To accomplish this, I would click the Total By drop down menu and select Customer.
Right click on the image to enlarge it.
The Open Purchase Order report has been improved, as it now displays an accurate Open Balance, however, you cannot modify the report to pull in Customer, Job, or Item (Cost Code) Information, however, it only provides a brief summary.
Right click on the image to enlarge it.
The Open Purchase-Orders by Job report has also been improved, as it now displays an accurate Open Balance.
Right click on the image to enlarge it.
In order for any of these reports to work correctly you will have to enable the use of Purchase Orders (Edit menu -> Preferences -> Items & Inventory -> Company Preferences -> Inventory and purchase orders are active option must be checked); and you MUST use Quantities when you create a Purchase Order, when you receive the item, or enter a bill against it.
Right click on the image to enlarge it.
My overall opinion is that for any company that issues Purchase Orders, this is a marked improvement in the overall functionality of QuickBooks.
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A reader asked the following question:
We are a small contractor in San Diego and we are wondering how we get around having to always do an inventory adjustment to get our purchases to the correct COGS account? We have (2) departments but they are both doing construction projects: Service dept does smaller installs and Contracts dept does the bigger jobs so I have been doing a JE to move the material from the Contracts material COGS account to the service COGS account.
Is there an add-on for QB Enterprise 8 that we could use?
Thank you so much for your website/blog. I’ve been reading it faithfully every day!
____________________________________________________________________
There are several inventory add-ons for QuickBooks Pro, Premier and Enterprise; check out these 3rd party add-ons at the Intuit Marketplace.
Recording costs and income with an item
Based on your comment about “always having to do an inventory adjustment in order to get your Purchases to the correct COGS account”, makes me think that perhaps your items are not correctly set up.
Make sure that your QuickBooks Inventory Items are set up so that they capture both the cost/purchase account as well as a sales account; this method is called a “double-sided” item.
When any type of QuickBooks Service, Inventory, Non-Inventory, Other Charge Item is set up this way you are able to capture the purchase price as well as the sales price.
When you enter a bill from a vendor for the inventory item (or write a check) you should be using the ITEM tab and not the Expense tab.
I’m confident that if you aren’t currently using the QuickBooks Purchase Order function that you would find that beneficial also.
Additionally, rather than using Journal Entries to classify whether it was the Service or Contracts Department – consider using “classes” to handle that.
For many contractors job costing is a key part of the success of their business – how else will they know if they are actually making a profit on the jobs they are bidding on.
Job costing in QuickBooks starts with the Item List. When you tell this to most contractors they respond with “Items — I don’t sell ITEMS — what does Items have to do with construction?????
This is a common feeling shared by many who use QuickBooks – not just contractors.
What is an “Item”?
By way of explanation, QuickBooks is a generic software program which can be used in any industry or business type; therefore, many of the terms in QuickBooks are generic and often confusing when trying to make it work in a specific industry. For example:
- For a shoe store, Items equals various types of footwear; sandals, work boots, dress boots, loafers, etc.
- For a contractors, Items equals various cost codes or divisions; Division 01 – General Requirements, Division 03-Concrete, 03.20.00 Concrete Reinforcing, etc.
- For a bakery, Items could equal different types of pastries, cakes, donuts, or pies.
The bottom line is this – your QuickBooks Item list should contain all the goods and/or services that you as a business “sell to OR charge your customer for.”
Creating an Item in QuickBooks
The second area of confusion for many QuickBooks users is the actual creating of an Item or Cost Code in the Item List.
When you access the Lists menu -> choose Item List -> click the Item button -> and select New – QuickBooks presents you with a very basic New Item window where you can select the Item Type, give it a Name/Number, make it a sub-item of another item, give it a description, a rate, assign a Tax Code to the Item and associate it with an Account (usually an Income Account).
Below is a screen shot of a “basic” item setup showing the Income or Revenue side of the item:
The “secret” to making this item work for job costing purposes is that VERY misleading checkbox statement – “This service is used in assemblies or is performed by a subcontractor or partner”.
Checking this option allows you to turn this item a powerful job costing tool.
When you check the option of “This service is used in assemblies or is performed by a subcontractor or partner”- information about the purchase or cost side of the item is now displayed.
Your Item window now displays both Purchase and Sales information – this procedure is commonly referred to as making an Item “double-sided”. It’s important to note that on the Purchase Information side of the transaction the “Expense Account” that you select can be EITHER an actual Expense Account OR a Cost of Goods Sold Account.
Making your Items Work for you
Once you have made your Item “double-sided” you then have to take a careful look at how you enter checks, bills from subcontractors, employee timesheets, etc.
When entering a bill, use the Items tab:
When you write a direct check to a vendor, use the Items tab:
When you enter an Employee’s timesheet, select the Item in the Service Item column:
All of these actions record your costs that are associated with this Item or Cost Code – and Job Costing is born.
Question:
How do I determine the Cost of Goods Sold for an item?
Answer:
I tell my clients that Cost of Goods Sold (COGS) is any cost incurred that directly relates to getting the sold goods out the door.
I have them ask the question “Would you have this expense if you hadn’t made the sale?”
Typical examples of COGS are product purchased for resale, subcontractors or vendors you hire specifically for preparing a product for sale, shipping materials like packaging, freight costs of receiving the resale product and shipping the product to your customers, payroll/labor costs of your employees who are directly related to preparing the goods to be sold or shipped out (would you have hired them if you didn’t have the product to sell?).
Costs that are not directly related to getting the product out the door are considered Expenses or Operating Expenses and include things like your liability insurance premiums, telephones, office supplies, office-related postage and delivery, advertising, clerical payroll, employee benefits and health insurance for the employees and would be considered costs of managing the paperwork for the overall business,
Again, if you would have the expense if you weren’t selling your product or service, it is an expense considered overhead. If you have the expense only because you selling the product or service, it’s COGS.
This is a very simplistic definition and there are certainly areas of disagreement among different people, but if you relate it strictly to your business you should be able to come up with your COGS vs Expenses.
In a nutshell…
Cost of Goods sold is anything and everything that costs you money to buy items for resale, have them delivered to your store to sell, package and label them, import them, fix them or otherwise make them fit to sell.
If it costs you $100 to purchase an item, $5.00 to have each one shipped to your store, it costs $2.50 each in import duty and taxes, $10.00 each to have them inspected by QC, and $5.00 each to fix little problems with each item, your COGS is $122.50.
