Companies that sell products need to know the cost of creating those products. They calculate this by using the cost of goods sold formula. The cost of goods will typically be shown in the company’s profit and loss account. It is also likely to be important for tax filings.
What is the cost of goods sold?
Cost of goods sold (COGS) is literally the cost of producing the goods a company then sells. In the case of physical goods, it generally includes the value of existing inventory plus any related materials and direct labour costs incurred over the year. It may also include the cost of packing and transporting the goods to their end destination.
Only companies that create products (including digital ones) can use the cost of goods sold – service industries use the concept of cost of revenue. That said, many companies may need to use both to some extent. For example, a company may offer a chargeable support service to people who buy its products. Likewise, many service companies also have a product line.
Cost of goods sold versus operating expenses
If a cost is directly attributable to the creation of a product, then it should be recorded under cost of goods sold. If it isn’t but does relate to the generation of revenue, then it belongs under operating expenses. Operating expenses are often known as selling, general and administrative expenses – these costs typically make up the bulk of this entry.
Cost of goods sold formula
At a basic level, the cost of goods sold formula is:
Starting inventory + purchases − ending inventory = cost of goods sold.
To make this work in practice, however, you need a clear and consistent approach to valuing your inventory and accounting for your costs.
Valuing your inventory
If your business is new, then you can determine the value of your inventory either by its purchase price or by the cost of goods formula. If you use the cost of goods formula, then you would use a value of zero for starting inventory. If your business is established, then the value of your starting inventory would be the same as the value of the ending inventory in the previous year. There are three ways you can value inventory. These are:
First in, first out
Last in, first out
Average cost method
FIFO accounting assumes that a company is selling its oldest products before its newest ones. And as prices tend to rise over time, the assumption is that a company is selling its more affordable products before its more expensive ones. LIFO accounting, by contrast, assumes the opposite.
The average cost method aims to eliminate the effect of inflation by valuing inventory based on the average price of all goods currently in stock. This has the added bonus of smoothing out the effect of significant ad hoc costs.
Whatever inventory valuation method you choose, it’s important to stick to it consistently. It’s also important to ensure that, where relevant, depreciation and amortisation are calculated accurately and that obsolete inventory is written off appropriately.
Accounting for purchases
There are basically two ways of accounting for expenses: the cash method and the accrual method. With the cash method, an expense is allocated to the date it was paid (and a benefit to the date it was received). This has the advantage of simplicity but the disadvantage of sometimes being misleading. Essentially you may pay (or receive payment) long after the action that triggered the expense (or benefit).
With accrual accounting, you record costs as soon as they have been fixed (or you can estimate them reasonably accurately). Similarly, benefits are recorded as soon as they have been earned (for example, you dispatch an invoice). This approach is more complicated but can offer a much more accurate picture of a business’ performance over time.
How we can help
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