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Cost of Goods Sold Formula: Definition, Formula, and Limitations

24 min read

Formula To Calculate Cost of Goods Sold (COGS)

The formula to calculate the Cost of Goods Sold is:

COGS = Beginning Inventory + Purchases – Closing Inventory

Where,

  • Beginning Inventory is the inventory of goods that were not sold and were leftover in the previous financial year
  • Purchases refer to the additional merchandise added by a retail company or additional production of goods undertaken by the manufacturing firm. These Purchases are added to the Beginning Inventory.
  • Closing Inventory refers to the goods that were not sold during the current financial year. Such inventory is subtracted from the sum total of Beginning Inventory and Purchases in order to calculate COGS.

COGS Basic Example

Benedict Company manufactures T-Shirts. The company is closing its books of accounts that showcases the following figures:

ParticularsAmount in US$
Beginning Inventory$50,000
New Purchases$500,000
Closing Inventory$20,000

Now, here’s how you need to calculate the COGS for Benedict Company Manufacturers.

COGS = Opening Stock + Purchases – Closing Stock

COGS = $50,000 + $500,000 – $20,000

COGS = $530,000

Thus, from the above example, it can be observed that the cost of the merchandise that Benedict Company Manufacturers has to sell cost him $530,000 leaving the closing inventory of $20,000.

Such calculation of COGS would help Benedict Company to plan purchases for the next financial year. In addition to this, the company can also determine the cost for each of its product categories and compare such costs with sales in order to determine the selling margin.

Such an analysis would help Benedict Company in determining the products that earn more profit margins and the products that are turning out too costly for the company to manufacture.

 


Merchandising and manufacturing companies generate revenue and earn profits by selling inventory. For such companies, inventory forms an important asset on their company balance sheet.

Merchandisers, including wholesalers and retailers, account for only one type of inventory, that is, finished goods as they purchase the ready for sale inventory from manufacturers.

On the other hand, manufacturers first purchase raw materials from suppliers and then transform these raw materials into finished goods. Therefore, manufacturers classify inventory into three categories: raw materials, work-in-progress, and finished goods Work-in-progress inventory is nothing but the inventory that is still under process and is not yet converted into finished goods to be sold to customers.

Now, in order to record the cost of inventories in the books of accounts, manufacturers can either record the amounts of raw materials, work-in-progress and finished goods separately on the balance sheet or simply showcase the total inventory amount.

Therefore, we can say that inventories and cost of goods sold form an important part of the basic financial statements of many companies.

International Financial Reporting Standards (IFRS) has stipulated three cost formulas to allow for inter-company comparisons. These include Specific Identification, First-In-First-Out (FIFO), and Weighted Average Cost Methods.

However, US Generally Accepted Accounting Principles (GAAP) allows the same three inventory valuation methods along with a fourth one, that is, the Last-In-First-Out Method.

Thus, the type of method used by a company to value its inventory has an impact on its ending inventory and cost of sales. So in this article, let us try to understand what is the Cost of Goods Sold, COGS Formula, and different Inventory Valuation Methods.

What is the Cost of Goods Sold (COGS)?

Cost of Goods Sold (COGS) refers to the costs associated with acquiring or manufacturing goods to be sold by a company during a specific period of time.

It includes only those costs that are directly incurred in order to manufacture the goods including the cost of labor, raw material, and overhead expenditure related to the manufacturing of goods to be sold.

The indirect costs such as sales and marketing expenses, shipping, legal costs, utilities, insurance, etc. are not included while determining COGS.

Therefore, COGS is calculated by adding the beginning inventory and any further purchases made during the year and then subtracting closing inventory from the sum of opening inventory and additional purchases.

Beginning inventory is nothing but the unsold inventory at the end of the previous financial year. Whereas, the closing inventory is the unsold inventory at the end of the current financial year.

The cost of goods sold also referred to as Cost of Sales is an important item on the income statement of your company as it helps in determining Gross Profit, a profitability measure that demonstrates the efficiency of your business in managing raw material and labor.

What is a Product Cost?

Product Cost refers to the costs incurred in manufacturing a product intended to be sold to customers. These costs include the costs of direct labor, direct materials, and manufacturing overhead costs.

In terms of services, product cost is the cost incurred on the labor required to deliver the services to customers. In the case of services, product cost must include all the costs that are associated with rendering services like employee compensation, employee benefits, and payroll taxes. or costs incurred in rendering a service to the final users.

Now, it is important for you as a business to calculate the per unit product cost as it helps you in setting an appropriate selling price for your product. Typically, the per-unit cost of your finished goods is derived by adding the costs incurred to produce a bunch of units and then dividing this cost by the number of units in the batch so produced.

Per Unit Product Cost = (Total Cost of Direct Materials + Total Cost of Direct Labor + Total Cost of Direct Overheads) / Total Number of Units

So, the cost of goods that are not yet sold but are ready for sale can be recorded as inventory (asset) in your balance sheet. However, as soon as such goods are sold, they become a part of the Cost of Goods Sold and appear as an expense in your company’s income statement.

Why Is It Important?

The Product Cost and Cost of Goods Sold are a few of the most important metrics on your financial statements. It is important to determine product pricing and COGS as it helps you to:

  • Determine the Selling Price

The Product Cost helps you to determine the selling price of your finished products and know whether your business has earned profits, incurred losses, or has achieved the break-even point.

If the per-unit selling price is greater than the per-unit cost of the product, then your business has earned profits. While if the per-unit selling price is less than the per-unit cost of your products, this means your business has suffered losses.

And to break even, the per-unit cost must be equal to the per-unit selling price of your products, that is, your selling price must cover the per-unit cost.

  • Calculate Gross Profit

COGS helps you to determine the gross profit for your business which is nothing but the difference between Revenues or Sales and COGS. It is the Gross Income that your business earns before subtracting taxes and other expenses.

Gross Profit is an important metric as it indicates the efficiency with which your business operates. It lets you know how efficiently your business is utilizing its labor and raw materials to manufacture its finished products.

Gross profit also helps to determine Gross Profit Margin, a percentage that indicates the financial health of your business.

  • Determine Net Income

COGS is the cost incurred in manufacturing the products or rendering services. It is recorded as a business expense on the income statement of your company.

Thus, by calculating COGS, various stakeholders of your company like managers, owners, and investors can estimate your company’s net income. Net income is the net earnings of your business that is calculated by deducting COGS and other expenses like Selling and Administrative Expenses, Operating Expenses, Depreciation, Interest, and Other Expenses from Sales or Revenue.

If COGS increases, the net income decreases which means fewer profits for your business. Therefore, it is important for you as a business to keep COGS low in order to earn higher profits.

COGS Formula (Extended)

In the above section, the basic COGS Formula was discussed. In this section, we are going to discuss COGS Formula extended charting out different components in detail.

COGS = Opening Stock + Purchases – Purchase Returns & Allowances – Purchase Discounts + Freight In – Closing Stock

Where,

  • Opening Stock: Is the beginning inventory of goods that were left unsold in the previous financial year.
  • Purchases: These are the additional purchases of raw materials to be converted into finished goods in case of manufacturers and additional finished goods in case of retailers.
  • Purchase Returns and Allowances: Purchase returns refer to the items that are returned to the suppliers. Whereas, allowances refer to any additional benefit received from the suppliers like rebates.
  • Purchase Discounts: These refer to the discounts received from the suppliers in the supply chain that help in further reducing the costs. Reduced costs mean an increase in your company profits.
  • Freight-In: This refers to the cost incurred on transportation in order to bring the raw materials to the place of production (manufacturing unit) in order to produce the finished products.
  • Closing Stock: Closing Stock is the ending inventory of goods that remains unsold at the end of the current financial year.

Examples 1, 2, 3

Following are some of the basic examples that would help you in explaining how to calculate COGS using the COGS Formula extended. Let’s consider the example of Benedictt Company that manufactures T-Shirts.

Example #1

Benedictt Company manufactures T-Shirts. The direct cost of manufacturing a T-Shirt is $20. Following are the figures pertaining to the year ending 2019:

ParticularsDescription
Opening Stock100,000 T-Shirts
Closing Stock40,000 T-Shirts
Costs Incurred During the Year
Purchases$300,000
Discounts Received$15,000
Freight In$40,000

Cost of Opening Stock = 100,000 x $20 = $2,000,000

Cost of Closing Stock = 40,000 x $20 = $800,000

Therefore, Cost of Goods Sold is calculated as mentioned below:

COGS = $2,000,000 + $300,000 – $15,000 + $40,000 – $800,000

COGS = $1,525,000

Example #2

Now suppose that Benedictt Company starts manufacturing Lowers apart from T-Shirts. Following are the figures of both the products pertaining to the year ending 2019:

Particulars of T-ShirtsDescription
Opening Stock40,000 T-Shirts
Closing Stock5,000 T-Shirts
Costs Incurred During the Year
Cost of one T-Shirt$20
Cost of material$200,000
Cost of Labor$800,000
Freight In$60,000
Particulars of LowersDescription
Opening Stock20,000 Lowers
Closing Stock2000 Lowers
Costs Incurred During the Year
Cost of one Lower$40
Cost of material$300,000
Cost of Labor$1,000,000
Freight In$100,000

In addition to the above direct costs, there are some overhead costs that Benedictt Company had to incur. These are mentioned below.

  • Rent of Factory (Annually): $100,000
  • Electricity Charges (Annually): $120,000
  • Foreman’s Salary: $80,000

COGS is calculated as follows:

The following table shows the Direct Cost of manufacturing T-Shirts.

Particulars of T-ShirtsUnitsPer Unit CostTotal Cost
Opening Stock (A)40,000$20$800,000
Closing Stock (B)5,000$20$100,000
Direct Cost
Cost of material$200,000
Cost of Labor$800,000
Freight In$60,000
Total Direct Cost (C)$1,060,000
COGS (A+C-B)$1,760,000
Particulars of LowersUnitsPer Unit CostTotal Cost
Opening Stock (A)20,000$40$800,000
Closing Stock (B)2,000$40$80,000
Direct Cost
Cost of material$300,000
Cost of Labor$1,000,000
Freight In$100,000
Total Direct Cost (C)$1,400,000
COGS (A+C-B)$2,120,000

Example #3

Now, let’s take an example of a food delivery services company, Zoot, that picks up parcels from various vendors and delivers it at the doorstep of the consumer. Below are the costs incurred during 2019.

  • Cost of picking up parcels from vendors: $400,000
  • Fuel Costs: $10,000,000
  • Cost of Labour: $500,000

In addition to the above mentioned costs, there might be other costs including marketing, traveling, administrative, and selling expenses. Since all these costs are indirect costs, these would not be considered while calculating COGS of Zoot for the year 2019.

COGS = $400,000 + $10,000,000 + $50,000 = $10,450,000

Calculating COGS and the Impact On Profits

COGS is an important metric on the income statement of your company. This is because the COGS has a direct impact on the profits earned by your company.

Now, it is important to note here that Gross Profit, which is a profitability measure, is calculated with the help of COGS. Thus, Gross Profit is nothing but the difference between Revenue and Cost of Sales.

As mentioned earlier, the Gross Profit is a profitability measure that reveals how efficiently your business manages its labor and supplies in the manufacturing process. That is, higher the COGS, lower is the Gross Profit and lesser the COGS, higher the Gross Profit.

But Gross Profit alone would not help in comparing the efficiency of your business from year-to-year or Quarter-to-Quarter. Therefore, in order to achieve that, you need to calculate Gross Profit Margin.

Gross Profit Margin is a percentage metric that measures the financial health of your business. It is calculated by dividing Gross Profit by Net Sales. Thus, if Gross Profit Margin fluctuates to a great extent, it may indicate inefficiency in terms of management or poor quality of products.

Calculating COGS using a Periodic Inventory System

As the name suggests, under the Periodic Inventory system, the quantity of inventory in hand is determined periodically. All inventories obtained during an accounting period are recorded as Purchases.

Thus, total purchases at the end of the accounting period are added to the opening inventory to calculate the cost of goods available for sale. Then, in order to calculate COGS, the ending inventory is subtracted from the cost of goods available for sale so calculated.

It is important to note that under the Periodic Inventory System, the inventory left at the end of the year (closing inventory) is counted physically.

Furthermore, under this method, there is always a chance of committing an error due to improper entry or failure to prepare or record the inventory purchased. As a result, the recorded inventory may differ from the actual inventory.

Therefore, physical periodic verification of the inventory records is required. The physically counted inventory is then compared with the recorded inventory and is corrected to match with the quantity actually on hand.

Let’s consider an example to understand how COGS is calculated under the Periodic Inventory System.

Example

Crompton Pvt Ltd had the following transactions during the current fiscal year.

ParticularsCost
Beginning Inventory100 units at $6 per unit = $600
Purchases900 Units at $6 per unit = $5,400
Sales600 Units at $12 per unit = $7,200
Ending Inventory400 Units at $6 = $2,400

Therefore, the COGS under the Periodic Inventory System is:

COGS = Opening Inventory + Purchases + Closing Inventory

COGS = $600 + $5,400 – $2,400 = $3,600

Calculating COGS using a Perpetual Inventory System

Under the Perpetual Inventory System of inventory valuation, only increases and decreases in the quantity of inventory (not the dollar amounts) are recorded in detail. This system of inventory helps in determining the level of inventory at any point in time.

That is, this method of inventory management records the sale and purchase of inventory thus providing a detailed record of the changes in the inventory levels. This is because the inventory is immediately reported with the help of management software and an accurate amount of inventory in stock as well as on hand is reflected.

That is to say, the Perpetual Inventory System records real time transactions of the inventory purchased or sold using an inventory management software.

Let’s consider an example

Calculating COGS Using FIFO

The First In First Out Method is based on the assumption that the goods are used in the sequence of their purchase. This means that goods purchased first are used or consumed first in a manufacturing concern and are sold first in case of a merchandising firm.

Accordingly, in FIFO method of inventory valuation, goods purchased recently form a part of the closing inventory. Now, in order to better understand the FIFO method, let’s consider the example of Harbor Manufacturers.

Case I – Under Periodic Inventory System

In this case let’s consider that Harbor Manufactures use a periodic inventory management system and FIFO method to determine the cost of ending inventory. Now, the cost of closing inventory is calculated by taking the cost of the latest or the most recent purchase and then calculating backwards till the time all the items in inventory are considered.

Suppose Harbor Manufacturers made the following transaction in its first month of operations:

DatePurchasesSoldBalance
October 8, 20192,000 Units at $4.002,000 Units
October 14, 20196,000 Units at $4.408,000 Units
October 18, 20194,000 Units4,000 Units
October 30, 20192,000 Units at $4.756,000 Units

From the above table, we can calculate the cost of ending inventory of 6000 units and cost of goods available for sale (beginning inventory + purchases) of $43,900 (2000 units @ $4.00 + 6000 units @ $4.40 + 2,000 @ $4.75).

Now, to calculate the cost of ending inventory and COGS, FIFO method is used.

DateNumber of UnitsUnit CostTotal Cost
October 302,000$4.75$9,500
October 144,000$4.40$17,600
Ending Inventory6,000$27,100

Thus,

Cost of Goods Available for Sale $43,900

(-) Ending Inventory $27,100

Cost of Goods Sold $16,800

Case II – Under Perpetual Inventory System

In this case, we will consider that Harbor Manufacturers uses the perpetual inventory system and FIFO method to calculate the cost of ending inventory and COGS.

Thus, in this case, cost is attached to each withdrawal or sale of items. Accordingly, goods sold on October 18, 2018 would comprise of purchases made on October 18, 2019 would comprise of purchases made on October 8, 2019 and October 14, 2019.

DatePurchasesSalesBalance
October 8, 20192,000 @ $4.00 = $8,0002,000 @ $4.00 = $8,000
October 14, 20196,000 @ $4.40 = $26,4002,000 @ $4.00 + 6,000 @ $4.40 = $34,400
October 18, 20192,000 @ $Rs 4.00 + 2,000 @ $4.40 = $16,8004,000 @ $4.40 = $17,600
October 30, 20192,000 @ $4.75 = $9,5004,000 @ $4.40 + 2,000 @ $4.75 = $27,100

As per the above table, on using the FIFO method, sales made on October 18, 2018 would comprise of:

  • Purchases made on October 8 (2000 units @ $4.00 = $8,000) and
  • Purchases made on October 14 (6000 units @ $4.40 = $26,400)

Thus, the ending inventory according to this method is $27,100 and the cost of goods sold is $16,800.

Calculating COGS using LIFO

The LIFO Method assumes that recent goods purchased are consumed first and the goods purchased first are consumed later.

Thus, the cost of goods sold is calculated using the most recent purchases whereas the ending inventory is calculated using the cost of the oldest units available.

Case I- Periodic Inventory System

In this case let’s consider that Harbor Manufactures use a periodic inventory management system and LIFO method to determine the cost of ending inventory.

Now, if the company uses a periodic inventory system, it is considered that the total quantity of sales made during the month would have come from the latest purchases.

DateUnitsUnit CostTotal Cost
October 8, 20192,000$4.00$8,000
October 14, 20194,000$4.40$17,600
Ending Inventory6,000$25,600

Goods Available For Sale $43,900

(-) Ending Inventory $25,600

Cost of Goods Sold $18,300

Hence, as per the above table, 4,000 units sold on October 14, 2019 would comprise of:

  • 2,000 units purchased on October 30, 2019 and
  • 2,000 units out of 6,000 units purchased on October 14, 2019

Case II – Perpetual Inventory System

In this case let’s consider that Harbor Manufactures use a perpetual inventory management system and LIFO method to determine the cost of ending inventory. Therefore, the ending inventory and cost of goods sold would be different as against the periodic inventory system.

DatePurchasesSalesBalance
October 8, 20192,000 @ $4.00 = $8,0002,000 @ $4.00 = $8,000
October 14, 20196,000 @ $4.40 = $26,4002,000 @ $4.00 + 6,000 @ $4.40 = $34,400
October 18, 20194,000 @ $4.40 = $17,6002,000 @ $4.00 + 2000 @ $4.40 = $16,800
October 30, 20192,000 @ $4.75 = $9,5002,000 @ $4.00+ 2,000 @ $4.40 + 2,000 @ $4.75 = $23,600

As per the above table, on using the LIFO method, sales made on October 18, 2019 would comprise of:

  • Purchases made on October 14 (4000 units @ $4.40 = $17,600)

Thus, the ending inventory according to this method is $23,600 and the cost of goods sold is $17,600.

Comparing COGS to Sales Ratios

The COGS to Sales ratio showcases the percentage of sales revenue that is used to pay for the expenses that vary directly with the sales of your business. This ratio indicates the efficiency of your business to keep the direct cost of producing goods or rendering services low while generating sales.

Therefore, the lesser the ratio, the more efficient is your business in generating revenue at a low cost. That is to say that the decreasing COGS to Sales ratio indicates that the cost of producing goods and services is decreasing as a percentage of sales.

However, an increasing COGS to Sales ratio would inculcate that the cost of generating goods or services is increasing relative to the sales or revenues of your business. Thus, there is a need to control the costs in order to improve the profit margins of your business.

This ratio also helps the investors in deciding the company stocks in which they must invest for a profitable portfolio. Thus, investors before investing in company stocks research the industry the business operates in and track the COGS to sales ratio in order to know the costs relative to the sales.

By tracking such a figure for a host of companies, they can know the cost at which each of the companies is manufacturing its goods or services. Thus, if one company is manufacturing goods at a low price as compared to others, it certainly has an advantage as compared to its competitors as more profits would flow into the company.

Thus, as an investor, you certainly need to be aware of the risks pertaining to higher COGS that companies may face.

The formula for COGS to Sales Ratio is as follows:

COGS to Sales Ratio = Cost of Goods Sold/Sales

Example

Suppose, Harbor Manufacturers has a Cost of Goods Sold of $100,000, the Sales for the current year is $200,000, and Sales return amounts to $50,000. Then,

Net Sales = $200,000 – $50,000 = $150,000

COGS to Sales Ratio = $100,000/$150,000 = 66.67%

Accounting Methods and COGS

It is probable that during a given accounting period, your business might purchase inventory at several different prices. Now, since the inventories are purchased at different prices, the challenge that arises is to divide the cost of goods available for sale between the cost of goods sold and the ending inventory.

Therefore, to overcome this challenge, various inventory valuation methods are used and the method thus selected has a great impact on the reported income of your business. Thus, you should choose such a method that clearly exhibits income of your business during a given accounting period.

Following are the methods of inventory valuation that are applicable to both manufacturing and merchandising inventories.

  1. FIFO Method

The First In First Out Method, also known as FIFO Method, is a method of inventory valuation that is based on the assumption that the goods are consumed in the sequence in which they are purchased.

This means the goods purchased first are consumed first in a manufacturing concern and in case of a merchandising firm are sold first.

Accordingly, under FIFO method, goods purchased recently form a part of the closing inventory.

The benefit of using FIFO method is that the ending inventory is represented at the most recent cost. Thus, FIFO method provides a close approximation of the replacement cost on the balance sheet as the ending inventory is made up of the most recent purchases.

However, the disadvantage of using FIFO method is that there is a mismatch between the current costs and the current revenues. This is because the oldest costs are considered and are matched with the current revenues. Thus, this can lead to misleading profit figures.

  • LIFO Method

The Last-In-First-Out Method, also referred to as the LIFO Method, is based on the assumption that goods purchased recently are consumed first and the goods purchased first are consumed in the near future.

Therefore, the cost of goods sold under LIFO Method is calculated using the most recent purchases. Whereas the closing inventory is calculated using the cost of the oldest units available.

The advantage of using LIFO method of inventory valuation is that it matches the most recent costs with the current revenues. Thus, it gives a better measure of profitability.

Furthermore, the LIFO method offers tax benefits to your business. This is because items recently purchased at higher price levels increase the cost of goods sold and reduce the net income. Thus, reduced net income means reduced taxes for your business.

However, the disadvantage of using the LIFO method is that it leads to lower profits for your business when inflation is high.

Reduced earnings further may be misinterpreted by the investors thereby reducing the company’s stock price. Further, the ending inventory in the balance sheet recorded at oldest costs understates the working capital position of the company.

  • Average Cost Method

The Average Cost Method to value the cost of ending inventory takes into consideration the average cost of items available for sale.This means that the units under costs of goods sold and the closing inventory are taken at the average cost so calculated.

In case you are using the periodic inventory method, the average cost is calculated using the weighted average method. Whereas, in case your business maintains inventory records using a perpetual inventory method, the average cost is calculated using the moving average method.

This method of inventory valuation is widely used as it is simple to use. Also, it is difficult to manipulate net income under this inventory pricing method.

  • Specific Identification Method

To apply the specific identification method of inventory valuation, it is necessary that each item sold and each item in closing inventory are easily identifiable.

Therefore, such a method is applicable only in cases where it is possible to physically differentiate the various purchases made by your business.

Thus, items sold at a specific cost during the accounting period can be included in the cost of goods sold. And the costs of particular items left or in hand can be included in the closing inventory.

Companies manufacturing or handling expensive, easily distinguishable items can successfully use this valuation method. Such items include automobiles, furniture, jewelry etc.

Exclusions From COGS Deduction

The Internal Revenue Service (IRS) department permits companies to deduct the cost of goods utilized to manufacture or purchase goods that need to be sold to the customers. Thus, the cost of all such goods is covered under Cost of Goods Sold that is showcased as one of the items in the Income Statement.

But not all firms can showcase such a deduction on their income statement. Businesses that offer services like accounting, real estate services, legal services, consulting services, etc instead of goods to their customers cannot showcase COGS on their income statement.

This is because such service-oriented businesses do not have any Cost of Goods Sold (COGS). In place of COGS, such service rendering companies have Cost of Services. Thus, Cost of Services is not the same as COGS deduction.

According to Generally Accepted Accounting Principles (GAAP), COGS is defined as the cost of inventory items sold to customers in a given period of time. Thus, this definition does not talk about any other detail with regards to COGS like cost of services.

So, if we consider companies providing services to their clients, such companies neither have goods to sell nor have any inventories. Therefore, in case of service companies, if COGS is not reflected in the income statement, then there can be no COGS deduction.

In fact, the service-oriented companies just have a Cost of Services that is not the same as COGS deduction.

Cost of Revenues Vs COGS

Cost of Revenues is not the same as Cost of Goods Sold. Cost of Revenues includes both the cost of production as well as costs other than production like marketing and distribution costs.

In other words, the cost of revenues takes into consideration:

  • cost of goods sold (COGS) in the case of manufacturing firms or Cost of Services in case of service providing companies and
  • all the additional costs incurred to produce goods or offer services for sale

Thus, the cost of the revenue takes into consideration COGS or Cost of Services and other direct costs of manufacturing the goods or providing services to the customers. Such cost would include costs like cost of material, labor, etc. however, it does not consider indirect costs such as salaries for determining the Cost of Revenue.

  • Cost of Revenue vs. COGS
  • Operating Expenses vs. COGS
  • Limitations of COGS
  • How do I calculate the cost of goods sold for a manufacturing company?
  • How is Cost of Goods Sold Affected by Inventory Costing Methods?

Are the Goods Purchased by a Retailer an Expense or an Asset?

Inventory Account

To balance c/d

What is the Difference between Inventory and the Cost of Goods Sold?

What is Inventory?

Inventory refers to the merchandise that is bought during the year but has not been sold to the customers. Inventory on the balance sheet comprises of :

  • raw materials
  • work-in-progress inventory
  • and finished goods owned by the manufacturer as on the balance sheet date.

Typically, inventory is valued at cost. It is one of the significant items that form part of the current assets of a business entity. You must remember that the per-unit cost of inventory changes over time. Hence, you must choose a method of accounting inventory such as LIFO, FIFO, average cost, and specific identification so that inventory cost can be expensed to COGS.

Also, one needs to keep track of inventory as less inventory could mean losing revenue and customers.

On the other hand, too much inventory could pose cash flow challenges as excess cash would be tied to inventory. In addition to this, excess inventory could also result in additional costs for the business in terms of insurance, storage, and obscene.

What is the Cost of Goods Sold?

The Cost of Goods Sold (COGS) refers to the direct cost of producing goods that are sold to customers during an accounting period. The COGS includes all the direct costs and expenses of producing the goods. The formula for calculating COGS involves adding opening stock, direct expenses, and purchases and then subtracting closing stock from this amount.

Unlike inventory, the COGS appears on the income statement right below the sales revenue. It is subtracted from revenue to calculate Gross Profit. Higher COGS means lower gross profit.

Since the inventory forms part of the COGS formula, the method of accounting inventory adopted by a business entity impacts its COGS.

 

Information may be abridged and therefore incomplete. This document/information does not constitute, and should not be considered a substitute for, legal or financial advice. Each financial situation is different, the advice provided is intended to be general. Please contact your financial or legal advisors for information specific to your situation.

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