What is the cost of goods sold and why is this important to know? The cost of goods sold is also referred to as the cost of sales and is the direct costs of producing the goods that are sold by a company. Cost of goods sold refers to the cost of goods that are either manufactured or purchased and then sold. This can also include the cost of the materials and labor required to make the goods. Cost of goods sold is considered an expense in accounting and it can be found on a financial report called an income statement.
Accounting Methods and COGS
It is important to note that the value of the cost of goods sold depends on the inventory costing method that a company adopts. There are three methods that a company can use for recording the level of inventory sold during an accounting period. The methods are; First in, First Out (FIFO), Last In, First Out (LIFO), and the Average Cost Method. The Special Identification Method is used for unique items.
With the First in, First Out inventory costing method assumes that the sale or usage of goods follows the same order in which they are bought. Assets that are produced or acquired first are sold, used, or disposed of first. Assets with the oldest costs are included in the income statement’s cost of goods sold. The most recent costs remain on the balance sheet, while the oldest costs are expensed first.
With Last In, First Out inventory costing method, inventory that is the most recently produced is sold first, and the most recent products purchased are the first to be expensed as the cost of goods sold. Only used in the United States, the LIFO method is used by U.S. companies with large inventories, such as retailers or auto dealerships.
Average Cost Method
The Average Cost Method is an inventory method that assigns a cost to inventory items based on the total cost of goods purchased or produced in a period divided by the total number of items purchased or produced. This is how a company assigns the value to the cost of goods sold as well as the cost of goods still available for sale using the Average Cost Method.
Special Identification Method
The Special Identification Method is used to find the ending inventory cost. In order to find the ending inventory cost, a detailed physical count is required so that the company knows exactly how many of each good bought on a specific date comprise the year-end inventory. The method is accounting for species identification as a method to determine inventory costs. This method can be used if individual items can be identified by a serial number and stamped receipt date.
Cost of Revenue vs. Cost of Goods Sold (COGS)
Where the cost of goods sold (COGS) refers to the costs involved in making the goods or services that are being sold, cost of revenues refers directly to the manufacturing, production, and distribution cost of a product or service of a company. Although both costs of revenue and COGS can be used interchangeably, there are some differences between the two. The main difference between them is that COGS does not consider the marketing or distribution costs of a good or service.
Operating Expenses vs. Cost of Goods Sold (COGS)
Operating expenses and cost of goods sold are different and separate expenditures that a business incurs. Operating expenses refer to expenditures that are not directly tied to the production of goods or services and include things like rent, utilities, office supplies, and any legal costs. Whereas the cost of goods sold refers to expenses directly related to the production of a product.
How Do You Calculate the Cost of Goods Sold (COGS)?
In order to calculate the cost of goods sold, you add the beginning inventory and the additional inventory costs, then subtract the ending inventory value. The formula for calculating COGS is:
Beginning Inventory + Purchases – Closing Inventory = COGS
Beginning inventory is the total cost of all your inventory of products at the start of your fiscal year. This should match the ending inventory for the previous fiscal year. The cost of purchases is the total of all the products purchased during the fiscal year that is available to sell, including raw materials less anything taken for personal use. Closing inventory is the total value of all remaining items still in inventory at the end of the fiscal year.
Say for example, if your business has a beginning inventory of $10,000 which would also include the total cost of all the inventory in the shop plus any other associated costs, your business may have incurred an additional $5,000 in costs. At the end of the year, after all sales, you calculate a closing inventory of $10,000.
Here is how you would calculate the cost of goods sold:
Beginning inventory: $10,000
Closing Inventory: $10,000
$10,000 + $5,000 – $10,000 = $5,000
Cost of goods sold: $5,000
Are Salaries Included in COGS?
Salaries are not included in the cost of goods sold, however certain types of labor costs can be included if they are directly associated with specific sales. Direct labor can be included in the COGS if the labor was primarily involved in the production of the goods.
How Does Inventory Affect COGS?
Cost of goods sold should include all the inventory that is sold during an accounting period. Companies often do not know the exact units of inventory that were sold. They use accounting methods such as First in, First Out (FIFO), and Last in, First out (LIFO) rules to get an estimate of the value of inventory that was actually sold during that period.