Is COGS a Credit or Debit? Accounting Explained
Unlock the complexities of Cost of Goods Sold (COGS). Discover its fundamental accounting principles and how it shapes business financial health.
Cost of Goods Sold (COGS) is a direct cost incurred by businesses that sell products. It plays a significant role in determining a company’s profitability, especially for retailers, manufacturers, and distributors. Understanding COGS is essential for assessing how efficiently a business manages its production and inventory.
What is Cost of Goods Sold?
Cost of Goods Sold (COGS) includes the direct expenses for creating or acquiring goods sold by a company. This covers raw materials, direct labor, and manufacturing overhead related to production. For example, for an automaker, COGS would include the cost of steel and assembly line worker wages.
COGS does not include indirect costs like marketing expenses, administrative salaries, or rent for an office building. These are considered operating expenses and are accounted for separately. COGS applies to businesses that produce goods, purchase items for resale, or offer services with direct costs associated with their delivery.
COGS Accounting Treatment
Cost of Goods Sold is categorized as an expense account in accounting. In the double-entry accounting system, increases in expense accounts are recorded as debits. Therefore, when goods are sold, COGS is debited, reflecting an increase in the cost of generating revenue. This debit signifies the outflow of economic benefits as the inventory is consumed to make a sale.
The corresponding credit entry for COGS reduces the Inventory account, which is an asset. When inventory is sold, its cost is transferred from the asset side of the balance sheet to the COGS expense account on the income statement. This process ensures that the accounting equation remains balanced, as the reduction in an asset (Inventory) is offset by an increase in an expense (COGS).
Impact on Financial Statements
COGS appears on a company’s income statement, directly below revenue. It is subtracted from net sales to calculate gross profit. Gross profit indicates how much revenue a company retains after covering the direct costs of producing or acquiring its goods.
A lower COGS relative to sales results in a higher gross profit, signaling greater efficiency in managing production costs. While COGS is an income statement item, it indirectly affects the balance sheet. As goods are sold, the value of inventory, an asset on the balance sheet, decreases. Accurate COGS reporting is important for tax purposes, as it is a deductible expense that reduces a business’s taxable income.