Inventory, Overhead, and Operating Costs

Inventory is merchandise held for sale. A physical count tells a business what it actually has; a stock record tells it what it expects to have. Compare both in units before assigning dollar values. In the figure, 100 + 150 − 180 = 70 bags should remain, but only 65 are counted.

For this simplified model, goods available at cost equals beginning inventory plus net purchases. Net purchases means purchases after returns and discounts, including any assigned freight-in. Cost of goods sold, or COGS, is the cost assigned to merchandise sold, not the selling price charged to customers.

A shortage between expected and counted inventory is shrinkage. Here 70 − 65 = 5 bags are missing, a $40 cost. Businesses investigate counting errors, damage, and theft rather than assuming every shortage is theft. Keep shrinkage separate from recorded sales cost in this lesson; subtracting physical ending inventory from goods available would combine both.

Turnover compares a period's COGS with average inventory at cost. Using the simple mean of beginning and ending inventory gives a useful estimate, but seasonal businesses may need monthly averages. Higher turnover can mean efficient selling or dangerously low stock, so compare similar businesses over the same period. Round money to cents and turnover to two decimal places.

Direct costs can be traced to a chosen product or job, such as ingredients used for a meal. Overhead supports operations but cannot conveniently be traced to a single unit, such as shared kitchen rent. The same cost can be direct for one purpose and indirect for another; always state the cost object.

An allocation base is a measurable activity used to divide a shared cost. Preparation hours may be reasonable for a kitchen; floor area might fit rent, and machine hours might fit equipment costs. A fair-looking base is not automatically a perfect measure of cost caused.

Divide the overhead pool by total activity to get an overhead rate. Then multiply each job's activity by that rate. Allocations must add back to the full overhead pool, aside from any disclosed rounding difference. Use a single consistent base within an allocation.

Full unit cost combines direct unit cost with allocated overhead per unit. This is useful for planning prices, but allocating fixed rent to a meal does not mean the rent disappears if one fewer meal is made. Do not add allocated overhead again after already including it in full cost. Round final money to cents; retain the unrounded allocation rate when necessary.

Operating profit is revenue minus the costs of running the business. In a simplified cost-volume-profit model, variable costs change in proportion to units sold, while total fixed costs remain unchanged within the relevant activity range. A monthly booth fee can stay fixed even when no posters sell.

Contribution margin per unit is price minus variable cost per unit. It first covers fixed costs; only after those costs are covered does additional contribution become operating profit. It is not the same as net income, which may also reflect interest, income taxes, and other items excluded here.

Break-even occurs when total contribution equals fixed costs. Divide fixed costs by contribution margin per unit. If products can only be sold whole, round the required unit count up, never to the nearest integer. A nonpositive contribution margin cannot cover positive fixed costs in this model.

To plan for a target operating profit, add that target to fixed costs before dividing. A plan is not a guarantee: price cuts, overtime, waste, or capacity limits can change the inputs. Use consistent time periods and round money to cents; do not round contribution margin before calculating required units.