Definition:
The cost of goods sold is the costs of goods or products sold during a specific period by the entity to its customers. The cost here refers to costs or expenses attributable directly to the goods or products that the entity sold, including the cost of direct labor, direct materials, and direct overheads.
These costs are recorded and presented in Income Statement right below total sales for the period, and they are used to calculate gross profits and gross profit margin.
Before going into the detail, it would be great to show you what you will get after completing this article. And here is a quick check:
Once finishing this article, you would understand the concept and principle of the entity’s cost of goods sold and how they are reporting and presenting in the financial statements.
You will understand the formula and know how to calculate the cost of goods sold during the period for your own company and the principle behind the formula.
You will gain this by example. Last but not least, you will know the factors that affect the cost of goods sold and know how to interpret or config the value of COGS.
Now let’s start with the concept and principle of COGS,
The cost of goods sold is not included operating expenses like sales and marketing expenses, administration expenses, interest, and tax.
The main objective of calculating the cost of goods sold is to find gross profit and compare the company’s gross profit margin to its competitors.
The current costing system should be further investigated when the company’s gross profit is smaller than its competitor’s.
And the production system in term of production efficiency and effectiveness probably are the areas that entity management need to review and assess to see if there is any room to improve. The economy of raw material purchasing is also contributed to the poor performance of gross profit margins.
However, other factors affect the cost of goods sold, for example, the valuation method of inventories, the ending balance, and the beginning balance of inventories.
We will discuss late this.
Formula:
Cost of Goods Sold for the period: Opening Inventories + Purchase – Closing Inventories
- Opening inventories are the inventory balance that is carried forward from the previous period. For example, if we are trying to calculate the costs of goods sold during 2020, the opening inventories we should use to calculate are the inventories balance as of 31 December 2019 or 1 January 2020.
- Purchasing inventories during the period we use to calculate the costs of goods sold are purchasing inventories from 1 Jan 2020 to 31 December 2020. Cut-off procedures should be carefully implemented by management to assure that it is correctly recorded.
- Ending or closing the inventory balance as of 31 December 2020 is essential. And it is the balance we should use to calculate the cost of goods sold for the year ending 31 December 2020.
Now, to illustrate the formula above we will provide an example of how to calculate the cost of goods sold below.
Example:
ABC Company, trading company, the end of its financial year is on 31 December. On 1 January 2020, the opening balance of inventories is $100,000. From 1 January 2020 to 31 December 2020, a purchased 100,000 goods cost $200,000 from suppliers.
It sold the goods for $3 per unit, and sales for the year amounted to $300,000 (100,000 units). On 31 December 2020, 50,000 unsold goods were remaining in inventory, valued at $2 each.
What is the ABC cost of goods sold? What is its gross profit?
Answer:
Cost of Goods Sold for the period: Opening Inventories + Purchase – Closing Inventories
- Opening Inventories= 100,000$
- Purchase = $200,000
- Closing Inventories = $100,000
Cost of goods sold for the period= $100,000 +$ 200,000 – $100,000= $200,000
Gross profit= $300,00 (Sales) – $200,000 =$100,000
Gross profit margin is 33.33% [(100,000/300,000)*100]
Cost of goods sold analysis:
As we can see, the cost of goods sold is $200,000, leading to a gross profit of 100,000. However, this gross profit might be the effect of the entity using different inventories valuation methods.
Generally speaking, inventories valuation methods include LIFO, FIFO, and Weight Average Cost and Inventories.
LIFO or Last In First Out is the valuation method that the ending balance of inventories is valued based on inventories that new purchase or assumed that the inventories that the company purchases are sold old inventories remain in stock.
This is not fair if the product or raw material price significantly fluctuates. This type of method is also not allowed based on the current accounting standard (IFRS).
Using this method, the ending inventories will be undervalued if the price of inventories purchased during the period goes up from the beginning and subsequently overstate the Cost of Goods Sold.
FIFO of First In First Out is another type of inventory valuation method. The cost of inventories will be based on the price of inventories purchased at the end of the period or assumed that the inventories are sold in the purchase order.
This method makes more sense than LIFO. It is allowed to use as per the current accounting standard (IFRS) if the ending value of inventories is not over or under whenever the purchasing price fluctuates.
Weight Average Cost is a bit straightforward among the three methods of inventories valuation, and the value of inventories is based on the average cost of inventories over total inventories. To make the calculation more sense, the average cost of inventories should be calculated based on their type.
In conclusion, the Cost of Goods Sold is the direct cost of the product sold during the period, and it could be different if different inventories valuation methods are used. The value of ending inventories is different if we use a different method to evaluate.
Is the cost of goods sold presently on the balance sheet?
No, the cost of goods sold is the income statement’s item and is not present in the balance sheet. However, before the company sells the goods or products to its customers, this cost is in the balance sheet items. It may belong to the raw materials, works in progress, or finished goods.
Is the cost of goods sold considered an asset or liability?
Costs of goods sold are not considered as the company’s assets, liabilities, and income. The cost of good solder is considered as expense in which the recognition and measurement are the same as other expenses. It is only present in the company’s income statement.
Can the cost of goods sold be negative?
No, it should not be negative, but it can be zero when the company sells the goods or services to its customer, the direct cost associated with the goods or services should be recognized. That cost of positive and it is deducted from the sale to arrive at gross profit. The company record only if the goods or services are sold or rendered. If there is no goods or services are sold, then the cost of goods sold is zero.
What are the critical massages that it tells you?
The cost of goods sold is the direct cost associated with the goods that the company sells to its customers. This cost tries to tell the users about the company’s costs on the products sold to customers.
More than that, the costs assist users in assessing the margin that the company could earn from the products by comparing the company’s expectations, competitors, and industry averages.
In addition, users could initially assess how well the company manages its procurement function in terms of economy, efficiency, and production process effectiveness.
The gross profit margin is also calculated by using the cost of goods sold. After the calculation, users will assess whether or not the entity’s gross profits could handle others’ sales and administrative expenses. This is really important for potential investors as they only want to invest in a profitable company.
Key limitation: The number could easily be manipulated: The company’s financial information is susceptible to all of the key stakeholders, especially the company’s management team.
This group of people is responsible for leading the company to achieve its objective. If management noted that the company’s cost of goods sold is higher than competitors or industry averages, management might manipulate the number of some related accounts like purchases during the year, returning to customers, opening balance of inventories, and ending balance of stocks.
These accounts are directly associated with the amounts of costs of goods sold. Different cut off between sales and costs for the same products also leads to over or understating the costs.
