Q. Can a business that sells its goods at a profit still run a negative gross margin if it purchases a lot of inventory?
A. The answer depends on what kind of accounting system you are using. If you are using a cash accounting system, the answer is yes, you can be selling your goods profitably and run a negative gross margin for some time. Alternatively, if you are properly executing an accrual accounting system, you cannot be selling your goods profitably and show a negative gross margin.
Let us use an example to illustrate. Assume that in the month of June you sold and received payment for $100,000 of goods. The material and labor it cost you to make the goods that you sold in June cost $50,000. For the purposes of this example, we will assume that you paid for all $50,000 of this cost in June. In addition, let’s assume that in June you bought and paid for $100,000 of raw material that you expect to use in July. You can see that, in this simple example, you are selling your goods profitably. You sold them for $100,000 and they cost only $50,000 to make. That’s a 50% margin.
In a cash accounting system, revenue is recognized when payment is received and cost is recognized when payment is made. In the above example, you received payment of $100,000. Therefore, revenue for June is $100,000. In June, you paid the $50,000 that it cost you for raw materials and labor to build the product you sold. Therefore, you will show costs of $50,000 in June. However, you also purchased and paid for $100,000 of inventory. In a cash accounting system, this $100,000 of inventory is also recognized as an expense in June because cash left the company.
Therefore, revenue for June is $100,000, but cost of goods in June is $150,000 ($50,000 that you paid for the material and labor that went into the product you sold plus $100,000 that you paid for inventory). This means that although you are making a 50% margin on the sale of your product, you will show a negative $50,000 gross margin in June using a cash accounting system. All else equal, you’ll show a very large gross margin in July, when you sell product that has no material cost associated with it (because this expense was recognized in June).
On the other hand, if you use an accrual accounting system this won’t happen. In this system, revenue is recognized when product is sold. The cost associated with the sale is also recognized when the product is sold. In other words, cost is matched to revenue. Therefore, in our example, revenue in June would still be $100,000. The cost of goods associated with this sale (i.e., $50,000) would also be recognized in June.
However, the $100,000 that was paid for additional raw material would not hit the income statement in June. That would be a balance sheet only transaction. Cash (an asset account) would go down by $100,000 since payment was made for the raw material. Inventory (also an asset account) would go up by the same $100,000 so that the balance sheet would remain balanced. This amount would remain in inventory until the product made from it is sold.
The benefit of a cash based accounting system is that it is simple. Revenue is recognized when cash comes in. Expense is recognized when cash goes out. As this example indicates, the primary drawback of a cash accounting system is that revenue and the cost associated with that revenue can hit the balance sheet in different accounting periods.
As you can see, a cash accounting system can lead to wild fluctuations in gross margin and in profit and makes it difficult to use the accounting system for good management decision making. For this reason, we typically recommend that our clients use an accrual accounting system for management decision making. Depending on the situation, it may make sense to use an accrual accounting system for management decision making and a cash accounting system for tax purposes.