How to Properly Record Cost of Goods Sold
Accurately account for your Cost of Goods Sold (COGS) to ensure precise financial reporting and a clear understanding of profitability.
Cost of Goods Sold (COGS) represents the direct costs incurred by a business to produce or acquire the goods it sells. Understanding COGS is foundational for any business, as it directly impacts profitability. COGS is a significant figure on a company’s income statement, positioned directly below revenue. This calculation is a primary determinant of a business’s gross profit, which indicates how much revenue remains after accounting for the direct costs of production. Furthermore, COGS functions as a deductible business expense, which can substantially reduce a company’s taxable income and, consequently, its tax liabilities.
Components of Cost of Goods Sold
The calculation of Cost of Goods Sold uses the formula: Beginning Inventory + Purchases (or Cost of Goods Manufactured) – Ending Inventory.
Beginning inventory is the value of goods available for sale at the start of an accounting period, carried over from the previous period.
For businesses that purchase goods for resale, “Purchases” is the total cost of merchandise acquired, including direct costs such as freight-in, which are expenses incurred to bring inventory to the business’s location.
For manufacturing businesses, “Cost of Goods Manufactured” replaces purchases. This includes direct materials, direct labor, and manufacturing overhead (indirect costs like factory utilities or equipment depreciation). Manufacturing overhead typically includes costs that cannot be directly traced to a specific product but are necessary for production.
Ending inventory is the value of unsold goods remaining at the close of the period. This figure is subtracted from the sum of beginning inventory and purchases (or cost of goods manufactured) to arrive at COGS. Accurate ending inventory valuation directly influences calculated COGS and reported profitability.
Inventory Costing Methods
Businesses utilize various inventory costing methods to assign values to inventory and, by extension, to the Cost of Goods Sold. These methods are based on assumptions about the flow of goods, rather than necessarily reflecting the physical movement of specific items. The choice of method can significantly affect a company’s reported profitability and inventory values.
The First-In, First-Out (FIFO) method assumes that the first goods purchased or produced are the first ones sold. Under FIFO, the Cost of Goods Sold is based on the cost of the oldest inventory items, while the ending inventory reflects the cost of the most recently acquired items. For instance, if a business bought 100 units at $10 and then 100 units at $12, and sold 150 units, the COGS would be calculated using the $10 cost for the first 100 units and the $12 cost for the remaining 50 units.
The Last-In, First-Out (LIFO) method operates on the assumption that the last goods purchased or produced are the first ones sold. Consequently, COGS under LIFO reflects the cost of the most recent inventory items, and ending inventory consists of the oldest costs. Using the previous example, if 150 units were sold under LIFO, the COGS would be calculated using the $12 cost for 100 units and the $10 cost for the remaining 50 units. It is important to note that LIFO is permitted under U.S. Generally Accepted Accounting Principles (GAAP) but is not allowed under International Financial Reporting Standards (IFRS).
The Weighted-Average method determines an average cost for all goods available for sale. This average cost is then applied to both the Cost of Goods Sold and the ending inventory. To calculate the weighted average, the total cost of goods available for sale is divided by the total number of units available for sale. If a business had 100 units at $10 and 100 units at $12, the total cost would be $2200 for 200 units, resulting in a weighted average cost of $11 per unit. If 150 units were sold, COGS would be 150 units multiplied by $11.
Recording Cost of Goods Sold
Recording Cost of Goods Sold involves distinct accounting procedures based on the inventory system a business uses. The two primary systems are perpetual and periodic inventory. Each dictates when and how COGS is recognized in financial records. The chosen system influences the timing of journal entries and the continuous tracking of inventory.
Under a perpetual inventory system, records update continuously with each purchase and sale. This system provides real-time information on inventory levels and the cost of goods sold. When a sale occurs, two entries are made: one for the sale (debit Cash or Accounts Receivable, credit Sales Revenue) and another for the cost of goods sold. The COGS entry debits the Cost of Goods Sold account and credits the Inventory account, reflecting reduced inventory assets.
A periodic inventory system does not continuously track inventory. Instead, COGS is determined and recorded only at the end of an accounting period (monthly, quarterly, or annually). This requires a physical count to ascertain the ending inventory balance.
Several closing entries are necessary to calculate COGS under this system. To calculate COGS in a periodic system, the Purchases account, which accumulates the cost of goods bought during the period, is closed. This effectively transfers beginning inventory and purchases into the COGS calculation, then adjusts for ending inventory.