COST OF GOODS SOLD

Definition:
Cost of goods sold is the accumulated total of all costs used to create a product or service, which has been sold. These costs fall into the general sub-categories of direct labor, materials, and overhead. In a service business, the cost of goods sold is considered to be the labor, payroll taxes, and benefits of those people who generate billable hours (though the term may be changed to "cost of services"). In a retail or wholesale business, the cost of goods sold is likely to be merchandise that was bought from a manufacturer.

In the income statement presentation, the cost of goods sold is subtracted from revenues to arrive at the gross margin of a business.
In a periodic inventory system, the cost of goods sold is calculated as beginning inventory + purchases - ending inventory. The assumption is that the result, which represents costs no longer located in the warehouse, must be related to goods that were sold. Actually, this cost derivation also includes inventory that was scrapped, or declared obsolete and removed from stock, or inventory that was stolen. Thus, the calculation tends to assign too many expenses to goods that were sold, and which were actually costs that relate more to the current period.

In a perpetual inventory system, the cost of goods sold is continually compiled over time as goods are sold to customers. This approach involves the recordation of a large number of separate transactions, such as for sales, scrap, obsolescence, and so forth. If cycle counting is used to maintain high levels of record accuracy, this approach tends to yield a higher degree of accuracy than a cost of goods sold calculation under the periodic inventory system.
The cost of goods sold can also be impacted by the type of costing methodology used to derive the cost of ending inventory. Consider the impact of the following two inventory costing methods:

First in, first out method (FIFO).
Under this method, known as FIFO, the first unit added to inventory is assumed to be the first one used. Thus, in an inflationary environment where prices are increasing, this tends to result in lower-cost goods being charged to the cost of goods sold.

Last in, first out method (LIFO).
Under this method, known as LIFO, the last unit added to inventory is assumed to be the first one used. Thus, in an inflationary environment where prices are increasing, this tends to result in higher-cost goods being charged to the cost of goods sold. For example, a company has $10,000 of inventory on hand at the beginning of the month, expends $25,000 on various inventory items during the month, and has $8,000 of inventory on hand at the end of the month. What was its cost of goods sold during the month?

The answer is:
Beginning inventory $10,000
+ Purchases 25,000
- Ending inventory 8,000
= Cost of goods sold $27,000

The cost of goods sold can be fraudulently altered by a number of means in order to change reported profit levels, such as:
Altering the bill of materials and/or labor routing records in a standard costing system
Incorrectly counting the quantity of inventory on hand
Performing an incorrect period-end cutoff
Allocating more overhead than actually exists to inventory

The cost of goods sold is the total expense associated with the goods sold in a reporting period. One way to calculate the cost of goods sold is to aggregate the period-specific expense listed in each of the general ledger accounts that are designated as being associated with the cost of goods sold.

This list usually includes the following accounts:
Direct materials
Direct labor
Factory overhead
Freight in and freight out

The list may also include commission expense, since this cost usually varies with sales. The cost of goods sold does not include any administrative or selling expenses.
In addition, the cost of goods sold calculation must factor in the ending inventory balance. If there is a physical inventory count that does not match the book balance of the ending inventory, then the difference must be charged to the cost of goods sold.
An alternative way to calculate the cost of goods sold is to use the periodic inventory system, which uses the following formula:
Beginning inventory + Purchases - Ending inventory = Cost of goods sold
Thus, if a company has beginning inventory of $1,000,000, purchases during the period of $1,800,000, and ending inventory of $500,000, its cost of goods sold for the period is $2,300,000.

To use the periodic inventory system, purchases related to manufactured goods must be accumulated in a "purchases" account.

The calculation of the cost of goods sold is not quite so simple as the general methods just noted. All of the following factors must also be taken into account:
- Charging to expense any inventory items that have been designated as obsolete
- Altering the cost of materials when a different FIFO or LIFO cost layer is used. Alternatively, an average costing method may be used to derive the cost of materials.
- Charging to expense any scrap that is considered abnormal, rather than charging it to overhead
- Charging to expense the difference between standard and actual costs for materials, labor, and overhead

There can also be differences in the cost of goods sold under the cash method and accrual method of accounting, since the cash method does not recognize expenses until the related supplier invoices are paid.
Given the issues noted here, it should be clear that the calculation of the cost of goods sold is one of the more difficult accounting tasks.
The cost of goods sold is usually separately reported in the income statement, so that the gross margin can also be reported. Analysts like to track the gross margin percentage on a trend line, to see how well a company's price points and production costs are holding up in comparison to historical results.