Costs of goods sold is an income statement component located and deducted after and from the total revenue figure. Costs of goods sold are the direct costs of material, labor, and overhead that are spent on the finished products manufactured that sold during the period.
The costs of goods sold are only correlated to the products that are sold and not for the products in the stock yet, as there are no associated units in the revenue. This is how the matching principle is used related to the costs of goods sold and revenue recognition.
The cost of goods sold directly describes the items sold only. COGS are the considerable costs incurred by a company when doing their operations.
What does the cost of goods sold comprise of?
The cost of goods sold comprises three main components including direct material, direct labour costs and direct overhead that were consumed to create finished products. It ignores other indirect costs such as indirect overheads, marketing, administration, and distribution costs.
Thus there are two major components of the cost of goods sold (also called cost of sales or cost of revenue), they are direct material and direct labour costs. These are explained below:
Direct material is the defined material that is exclusively injected in the production of units that the company sells.
As there may be a plentiful number of inventory items tied in with the production of selling units, the most peculiar characteristic of direct material is that they are precisely bound with finished products; and inventory consumed vary directly with the increase of finished products.
In the case of manufacturing companies, it is the tangible shape of the product that we can see with our naked eyes.
Examples of some direct materials are the wood materials used in the production of chipboards or wheat used in the production of final food items in the food industry.
Some indirect materials are the costs of stores and spares used in the maintenance of the machinery or depreciation that occurred on fixed assets in a company.
Direct labour costs are expenditures that arise because of the labour force that is directly involved in the production of the manufacturer’s products. The costs of labour involved in the production of products are also called prime labour costs.
As explained above, like direct material, direct labour costs vary with the output of finished products. These also include the temporary labour hired for the short term or the benefits and fringes paid to employees involved directly.
However, there does not include employee’s costs of other sections such as administration employees who are categorized in indirect labour or overhead costs. Direct labour costs increase as the output quantity of finished products increase.
Calculation of cost of goods sold:
The cost of goods sold is calculated by the summation of direct labour and direct material costs. Direct labour can be calculated easily however; calculation of direct material costs needs further processing of related figures.
As we have to only consider the costs associated with the items sold, in the cost of sales, we use the following formula to calculate direct material costs:
COGS = Opening stock + Purchases – closing stock
This formula describes that because the closing stock is still owned by the company, this is subtracted from the opening stock plus further purchases during the year so we get the material cost that is consumed directly by sold units.
Opening stock can be derived from the current assets section of the balance sheet of the previous year. Closing stock can be extracted from the inventory head in the current assets section of the balance sheet of the current year.
Purchases are the total purchases made during the year by the company. Using these values in the above formula, we finally derive the cost of goods sold.