Is Cost of Goods Sold a Credit or a Debit?

For any business that sells products, understanding the Cost of Goods Sold (COGS) is fundamental. This accounting term represents the direct costs attributable to the production of goods sold by a company. Grasping how COGS functions within a business’s financial framework is important for evaluating profitability and making informed decisions. It directly influences how much profit a company makes from its sales.

Fundamentals of Debits and Credits

Modern accounting relies on the double-entry system, where every financial transaction affects at least two accounts. This system uses debits and credits to record these changes, ensuring that the accounting equation (Assets = Liabilities + Equity) remains balanced. Debits are recorded on the left side of an account, while credits are recorded on the right side. This opposing nature maintains the balance across all financial records.

For asset and expense accounts, a debit increases the account balance, and a credit decreases it. Conversely, for liability, equity, and revenue accounts, a credit increases the balance, and a debit decreases it.

Defining Cost of Goods Sold

Cost of Goods Sold (COGS) represents the direct costs associated with producing the goods a company sells during a specific period. These costs are directly tied to the creation or acquisition of inventory that has been sold. For manufacturers, COGS includes the cost of raw materials, direct labor, and manufacturing overhead.

Retailers include the direct purchase price of the inventory for resale. Regardless of the business type, COGS is classified as an expense account. It is a component in determining a company’s gross profit.

Recording Cost of Goods Sold

As an expense account, the Cost of Goods Sold (COGS) increases with a debit.

The corresponding credit entry is made to the Inventory account. Crediting the Inventory account reduces its balance, reflecting that the goods have been removed from inventory and sold. For instance, if a business sells goods that originally cost $500, the journal entry involves a debit of $500 to the COGS account and a credit of $500 to the Inventory account.

Businesses use different inventory systems, which affect when COGS is recorded. Under a perpetual inventory system, COGS is recorded continuously at each sale. In contrast, a periodic inventory system records COGS at the end of an accounting period, after a physical count. Both systems ultimately result in COGS being a debit when recognized.

Impact on Financial Statements

Cost of Goods Sold has a direct impact on a company’s financial statements, primarily the income statement. On the income statement, COGS is subtracted from net sales revenue to calculate gross profit. This calculation provides an initial measure of profitability, showing how much revenue is left after covering the direct costs of producing or acquiring the goods sold.

While COGS is an income statement item, it also indirectly affects the balance sheet. As goods are sold and COGS is recognized, the Inventory asset account decreases. This reduction in inventory, combined with the impact of net income on retained earnings, influences the overall equity of the business.