When a business purchases goods from a supplier it will often return some of the goods, seek allowances against retained damaged goods, and obtain purchase discounts for early settlement of its accounts with suppliers. The combination of these amounts results in a net purchases figure to be included in the income statement at the end of the accounting period.
Net Purchases Formula
Purchases is the amount invoiced to the business by suppliers for the goods supplied during the accounting period. The purchases account is normally a debit balance and increases the net purchases.
Purchase returns are goods physically returned by the business to the supplier during the accounting period. The purchase returns account is normally a credit balance and reduces the net cost of purchases.
Purchase allowances are allowances given by the supplier in respect of goods retained by the business where an amount is deducted in respect of damages, faults and defects etc. The purchase allowances account is normally a credit balance and reduces the net purchases.
Purchase discounts are cash discounts given to the business by the supplier for early settlement of their account. The purchase discount account is normally a credit balance and reduces the net cost of purchases.
Net Purchases Example
As an example of how to find the net purchases, suppose a business purchases goods from a supplier for the amount of 250,000 spending a further 30,000 on freight costs to have the goods delivered to its warehouse.
On inspection the business finds that goods costing 2,000 were damaged beyond repair and returns these to the supplier. In addition other goods were not as ordered but the business decides to keep the goods and negotiated an allowance of 4,000 with the supplier
Finally, the business settles the account of the supplier within the time period required to obtain early settlement discounts of 5,000.
The net purchases is calculated as follows.
|Purchase returns||– 2,000|
|Purchase allowances||– 4,000|
|Purchase discounts||– 5,000|
The gross purchases cost is 250,000, after deducting purchases returns (2,000), allowances (4,000) and discounts (5,000), the net purchases is 239,000. This amount is now used to calculate the cost of goods purchased.
Net Purchases and Cost of Goods Purchased
The calculation of net purchases above is simply the net cost of the physical goods supplied. To arrive at the cost of goods purchased the business needs to add the freight-in costs necessary to have the goods delivered to its warehouse.
Cost of goods purchased = Net purchases + Freight-in
In the cost of goods purchased equation the terms have the following meaning.
Freight-in is the costs incurred in having the goods delivered to the business. The freight-in account is normally a debit balance and increases the cost of goods purchased.
In the above example the freight-in costs were 30,000 and the cost of goods purchased is calculated as follows.
|Cost of goods purchased||269,000|
The total cost to the business of purchasing the goods is 269,000. This amount is now used to calculate the cost of goods sold.
Cost of Goods Purchased and Cost of Goods Sold
The cost of goods purchased forms a major component of the cost of goods sold calculated by adjusting for inventory movements during the period as follows.
|Cost of goods purchased||269,000|
|Goods available for sale||319,000|
|Ending inventory||– 65,000|
|Cost of goods sold||254,000|
The beginning inventory plus cost of goods purchased is referred to as the goods available for sale. The cost of goods sold is arrived at by deducting the amount remaining in the ending inventory at the end of the accounting period.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.