How to Record Cost of Goods Sold (COGS)

Cost of Goods Sold (COGS) represents the direct expenses a business incurs to produce the goods it sells. These costs include the materials and labor directly used in creating a product. For retail, COGS primarily involves the cost of purchasing merchandise for resale. Understanding COGS is fundamental for evaluating a company’s financial performance and profitability.

COGS provides insight into a business’s production and purchasing efficiency. Deducting COGS from revenue yields gross profit, a key indicator of cost management relative to sales. COGS is also a deductible business expense, reducing taxable income. Accurate COGS calculation aids in setting product pricing and making informed cost management decisions.

Inventory Accounting Systems

Businesses choose an inventory accounting system to track goods and determine COGS. The two primary systems are the Perpetual Inventory System and the Periodic Inventory System. These systems dictate how inventory levels are updated and COGS is calculated.

The Perpetual Inventory System continuously updates inventory records with each purchase and sale. This system maintains real-time inventory quantities and costs, allowing businesses to know the exact number of items on hand and their cost. When a sale occurs, the system automatically records both the revenue and the corresponding COGS for the item sold. This provides immediate visibility into inventory levels and cost of goods sold.

In contrast, the Periodic Inventory System does not continuously track inventory. Businesses using this method perform a physical count of inventory at specific intervals, typically at the end of an accounting period. This count determines the ending inventory balance. COGS is then calculated indirectly by adding the cost of purchases to the beginning inventory and subtracting the ending inventory. This system offers less frequent updates, requiring a physical count to determine final figures.

Determining Inventory Costs

The cost assigned to inventory items directly impacts COGS calculation and remaining inventory valuation. Inventory costs generally encompass all expenditures to bring an item to its current condition and location. This includes purchase price, freight-in costs, direct labor, direct materials, and manufacturing overhead for produced items.

Businesses use various cost flow assumptions to assign costs to inventory and COGS, especially when identical items are purchased or produced at different prices. The First-In, First-Out (FIFO) method assumes the first goods purchased are the first ones sold. Under FIFO, COGS reflects the cost of the oldest inventory, while ending inventory is valued at the cost of the most recently acquired items. This method often aligns with the physical flow of goods, particularly for perishable items.

The Last-In, First-Out (LIFO) method assumes the last goods purchased are the first ones sold. COGS under LIFO reflects the cost of the most recent inventory acquisitions, and ending inventory is valued at the cost of the oldest items. This method can result in a higher COGS during periods of rising costs, leading to lower reported profits and potentially reduced tax liabilities. LIFO is not permitted under International Financial Reporting Standards (IFRS) but is allowable under U.S. Generally Accepted Accounting Principles (GAAP) for tax purposes.

The Weighted-Average Method calculates the average cost of all available goods for sale during a period. This average cost is applied to both units sold (COGS) and units remaining in inventory. To determine the weighted-average cost, the total cost of beginning inventory and all purchases is divided by the total number of units available for sale. This method smooths out cost fluctuations, providing a more consistent cost per unit.

Recording Cost of Goods Sold

Recording Cost of Goods Sold involves distinct journal entries depending on the inventory accounting system. These entries reflect inventory movement and expense recognition. The specific cost flow assumption (FIFO, LIFO, or weighted-average) determines the monetary value assigned to goods sold.

Under the Perpetual Inventory System, COGS is recorded at the time of each sale. When a product is sold, two journal entries are made: one for the sale and another to record the cost of the goods sold (debiting Cost of Goods Sold and crediting Inventory).

For businesses using the Periodic Inventory System, COGS is not recorded with each sale. Purchases of inventory are debited to a Purchases account. At the end of the accounting period, an adjusting entry determines and records COGS. This entry involves removing the beginning inventory balance, adding total purchases, and adjusting for the ending inventory determined by a physical count. The formula for periodic COGS is: Beginning Inventory + Purchases – Ending Inventory.

Reporting Cost of Goods Sold

Cost of Goods Sold is a key line item on a company’s financial statements, providing information about operational efficiency and profitability. Its placement and presentation are standardized for comparability and clarity for financial statement users.

COGS is reported on the Income Statement, directly below Sales Revenue. This allows for the immediate calculation of Gross Profit, derived by subtracting COGS from Sales Revenue. For example, if a company has $1,000,000 in Sales Revenue and $600,000 in COGS, its Gross Profit would be $400,000. This figure indicates profit earned before operating expenses like selling, general, and administrative costs.

While COGS appears on the Income Statement, the inventory from which it is derived is presented on the Balance Sheet. Inventory is classified as a current asset. The value of ending inventory on the Balance Sheet is directly influenced by the inventory costing method, which impacts the COGS figure on the Income Statement. Analyzing COGS with other financial metrics, such as gross profit margin (Gross Profit divided by Sales Revenue), offers insights into pricing strategies and cost control.