If your business carries an inventory, you can calculate your net purchases based on the figures in your ledgers. Gross purchases are the price of the inventory you buy during an accounting period. Net purchases are gross purchases minus discounts and returns. Net purchases is one of the figures you use in figuring your cost of goods sold.

Tip

To calculate net purchases, find the Purchases, Purchases Discount and Purchases Returns and Allowances accounts in your general ledger. In the net purchases equation, you subtract discounts, returns and allowances from the purchase price to get the net amount.

## The Net Purchases Equation

If purchasing inventory were purely an instant cash-for-goods transaction, accounting for it would be simpler. In practice, buying inventory is a drawn-out process. Suppose, for example, that you buy \$20,000 worth of handbags and other leather goods for your store:

• You make the purchase on credit, recording \$20,000 to your Purchases account and \$20,000 in Accounts Payable.

• Six \$300 handbags turn out to have broken clasps. You return them two weeks later for a \$1,800 refund which you record in Returns.

• A couple of handbags have minor flaws. You keep them but get a \$200 mark-down from the vendor, noting it in Allowances.

• You settle your account early, earning a 5% discount, equal to \$1,000. That goes in the Discounts account.

• With the bill paid, you wipe the \$20,000 out of Purchases and report the amount you paid in Cash.

The initial \$20,000 was your gross purchase. Using the net purchases equation, you take the gross and subtract the total discounts, returns and allowances to get a net purchase figure of \$17,000.

## Purchase Discounts Lost

Some retailers prefer to record the purchase price adjusted for discounts rather than the gross purchase price. This is known as the net method. Suppose you always settle accounts early when doing so gives you a discount. Rather than record the \$20,000 in Purchases and \$1,000 in Discounts, you simply enter \$19,000 in the Purchases account.

The advantage of going with the net method is that if you regularly get the early payment discount, the net approach is a more accurate representation of your liabilities.

If you screw up for some reason and don't pay soon enough to get a discount, you have to acknowledge that. When you credit Cash for the \$20,000 payment, you debit \$19,000 from Purchases and enter \$1,000 in Purchase Discounts Lost.

## Judging Your Performance

Discounts, even small ones, can add up over time. If you can score even a 1% or 2% discount by paying two or three weeks early, it's usually worth it.

The difference between gross purchases and net purchases shows how much you're saving. If the net purchases equation shows they're the same figure, that's a sign you're not earning discounts, or that the vendors aren't offering them. If you can either speed up your payments or get tougher in price negotiations, you may be able to save significantly.

## Cost of Goods Purchased

Once you know your net purchases figure, you can use it in the cost of goods purchased formula. This calculation is simple: take the net purchase figure for the accounting period and add in any freight costs you paid for shipping. Freight can easily add up to more than 10 percent of the purchase price, so negotiating for the vendor to pay is often a smart move.

The cost of goods purchased is the basis for your store markup. If shipping costs add, say, another \$2,000 to the purchase, you'll need to set a higher price in your store to recover it.

Your cost of goods purchased is a factor in a key inventory calculation formula, the cost of goods sold. Your cost of goods sold for the accounting period equals the beginning inventory plus the cost of goods purchased, less the ending inventory. You subtract COGS from net sales to determine your gross margin.