How to Record Cost of Sales in a Journal Entry

Cost of Sales (COS), also known as Cost of Goods Sold (COGS), is a fundamental financial accounting concept for businesses selling goods. It reflects the direct costs to acquire or produce items sold during a period. Understanding Cost of Sales is important because it directly influences a business’s reported profitability, particularly the gross profit margin. A journal entry is the initial record of any financial transaction, documenting debits and credits that form the basis for financial statements.

Understanding Cost of Sales

Cost of Sales encompasses the direct expenses tied to creating or acquiring products a business sells. For manufacturing companies, these direct costs include direct materials (raw materials that become part of the finished product) and direct labor (wages paid to workers directly involved in production). Manufacturing overhead, such as factory utilities or depreciation on production equipment, also contributes to these costs.

Merchandising businesses, which purchase goods for resale, include the direct purchase price of inventory as their primary Cost of Sales component. This includes the amount paid to suppliers for merchandise, plus any costs to bring the goods to a salable condition, such as freight-in charges. Cost of Sales is directly matched against the revenue from the sale of those goods, following the matching principle of accounting. This pairing allows businesses to accurately calculate their gross profit, which is sales revenue minus Cost of Sales.

Inventory Accounting Systems

Businesses use one of two primary inventory accounting systems to track merchandise and determine Cost of Sales. The perpetual inventory system continuously updates inventory records in real-time with each purchase and sale. This system maintains a running balance of inventory and automatically calculates Cost of Sales at the moment each sale occurs. It provides up-to-the-minute information on inventory levels, which can be beneficial for managing stock.

Conversely, the periodic inventory system does not maintain continuous, real-time inventory records. It relies on a physical count of inventory at the end of an accounting period to determine goods on hand. Under this system, Cost of Sales is not calculated with each sale but is determined only at the end of the period through a specific calculation. This approach typically involves less record-keeping throughout the period but requires a comprehensive physical count to ascertain inventory values and Cost of Sales.

Journal Entries for Perpetual Inventory System

Under the perpetual inventory system, two journal entries are required for each sale. The first entry records the sales revenue. For instance, if a business sells goods for $1,000 on credit, it debits Accounts Receivable for $1,000 and credits Sales Revenue for $1,000. This entry recognizes the increase in assets (receivables) and revenue from the transaction.

Immediately following the sales revenue entry, a second entry records the Cost of Sales and reduces the inventory balance. If the goods sold for $1,000 had an original cost of $600, the business debits Cost of Sales for $600 and credits Inventory for $600. This entry reflects the expense associated with the goods leaving inventory and simultaneously decreases the asset value of inventory. These two entries ensure both revenue and corresponding cost are recognized concurrently, providing an accurate portrayal of gross profit.

When a customer returns goods, corresponding journal entries reverse the original transactions. If goods sold for $100 (original cost $60) are returned, the first reversal debits Sales Returns and Allowances for $100 and credits Accounts Receivable (or Cash if a refund was issued) for $100. This reduces recognized revenue and the amount owed.

The second reversal entry reinstates the returned goods into inventory and reduces the Cost of Sales previously recognized. The business debits Inventory for $60 and credits Cost of Sales for $60. This ensures the inventory asset increases by the cost of returned items and the Cost of Sales expense adjusts downwards. The perpetual system continuously updates both Inventory and Cost of Sales accounts with every sales and return transaction.

Journal Entries for Periodic Inventory System

The periodic inventory system records inventory purchases differently than the perpetual system. When a business acquires inventory, it debits a temporary account called Purchases instead of directly debiting the Inventory asset account. For example, if a company purchases $500 worth of goods on credit, the journal entry is to debit Purchases for $500 and credit Accounts Payable for $500. This approach accumulates all inventory acquisitions in the Purchases account.

If a business returns goods to a supplier, a Purchase Returns and Allowances account tracks these reductions. For a return of $50 worth of goods, the entry debits Accounts Payable (or Cash) for $50 and credits Purchase Returns and Allowances for $50. Freight-in costs, expenses to bring purchased inventory to the business, are typically debited to a separate Freight-In account.

Under the periodic system, Cost of Sales is not recorded at the time of each sale. It is calculated and recorded through an adjusting entry at the close of the accounting period. The calculation is: Beginning Inventory + Net Purchases (Purchases minus Purchase Returns and Allowances, plus Freight-In) – Ending Inventory (determined by physical count). This formula yields the Cost of Sales for the entire period.

The end-of-period adjusting entry closes temporary accounts related to inventory and establishes Cost of Sales. This entry typically debits Cost of Sales for the calculated amount and debits the new Ending Inventory balance. Simultaneously, the Beginning Inventory, Purchases, Purchase Returns and Allowances, and Freight-In accounts are credited to zero out their balances. This entry transfers the cost of goods available for sale into Cost of Sales and updates the inventory asset for the next period.