Can You Find Cost of Goods Sold on a Balance Sheet?
Uncover where Cost of Goods Sold is actually found on financial statements and its connection to balance sheet elements.
Cost of Goods Sold (COGS) represents the direct costs a business incurs to produce the goods it sells. Understanding COGS is fundamental for assessing a company’s financial performance, as it directly impacts profitability. It specifically accounts for expenses like raw materials, direct labor, and manufacturing overhead used in making a product. By deducting COGS from revenue, businesses can determine their gross profit, which provides insight into the efficiency of their production process.
Where Cost of Goods Sold is Reported
Cost of Goods Sold is not reported on a company’s Balance Sheet. Instead, it is a prominent line item on the Income Statement, also known as the Profit and Loss (P&L) Statement. The Income Statement provides a view of a company’s financial performance over a specific period, such as a quarter or a year, outlining revenues and expenses to arrive at net income.
In contrast, the Balance Sheet presents a snapshot of a company’s financial position at a single point in time. It details what a company owns (assets), what it owes (liabilities), and the owners’ stake (equity). The fundamental difference lies in their purpose: the Income Statement measures performance over time, while the Balance Sheet shows financial standing at a specific moment.
The placement of COGS on the Income Statement aligns with the “matching principle.” This principle dictates that expenses should be recognized in the same accounting period as the revenues they helped generate. For example, when a product is sold and revenue is recorded, the costs directly associated with producing that product (COGS) are also recognized in the same period. This ensures financial statements accurately reflect the true profitability of sales transactions. Adhering to this principle provides a clearer picture of a business’s operational efficiency and profitability for stakeholders.
Calculating Cost of Goods Sold
The calculation of Cost of Goods Sold follows a standard formula: Beginning Inventory + Purchases – Ending Inventory. This formula determines the cost directly attributable to goods sold during a specific period.
Beginning Inventory is the value of goods a company has on hand at the start of an accounting period, typically the Ending Inventory from the previous period. It represents the stock available for sale before any new purchases or production activities begin.
Purchases in the COGS formula include the total cost of all new inventory acquired or produced during the accounting period. For manufacturing businesses, “Purchases” encompasses:
Direct materials: Raw goods that become part of the finished product.
Direct labor: Wages paid to employees directly involved in production.
Manufacturing overhead: All indirect costs associated with the factory or production process that cannot be directly traced to specific products.
For example, if a company started with $10,000 in inventory, purchased $50,000 worth of new materials and incurred production costs, and then ended the period with $15,000 in inventory, the COGS would be calculated as $10,000 + $50,000 – $15,000 = $45,000.
Ending Inventory represents the value of goods remaining unsold at the close of the accounting period. This amount is determined by a physical count or inventory tracking systems. An accurate ending inventory value directly impacts the calculated COGS, gross profit, and taxable income.
The Role of Inventory on the Balance Sheet
While Cost of Goods Sold is an expense on the Income Statement, its calculation is linked to Inventory, a current asset on the Balance Sheet. Inventory represents the value of goods a company holds for sale, goods in production, or materials for production. The ending inventory value on the Balance Sheet for one period becomes the beginning inventory for the next period’s COGS calculation.
Changes in inventory levels on the Balance Sheet directly influence the COGS figure on the Income Statement. For instance, if ending inventory is lower than beginning inventory, more goods were sold than purchased or produced, leading to a higher COGS. Conversely, an increase in inventory indicates fewer goods were sold relative to what was available, resulting in a lower COGS.
Businesses must choose an inventory valuation method to assign costs to both remaining inventory on the Balance Sheet and goods sold (COGS) on the Income Statement. Three common methods are:
First-In, First-Out (FIFO): This assumes the first units purchased or produced are the first ones sold. It generally results in a lower COGS and a higher ending inventory value during periods of rising costs, as older, cheaper costs are expensed first.
Last-In, First-Out (LIFO): This assumes the last units purchased or produced are the first ones sold. In an environment of rising costs, LIFO typically leads to a higher COGS and a lower ending inventory value, as newer, more expensive costs are expensed first.
Weighted Average Cost: This method calculates an average cost for all units available for sale and applies that average to both COGS and ending inventory. It tends to smooth out price fluctuations, resulting in COGS and inventory values that fall between FIFO and LIFO outcomes.
The choice of method can significantly impact a company’s reported profitability and asset value.