Definition:

The cost of goods sold is the costs of goods or products sold during a specific period of time by the entity to its customers. The cost here refers to costs or expenses that attributable directly to the goods or products that the entity sold which include the cost of direct labors, direct materials, and direct overheads.

These costs record and present in Income Statement right below total sales for the period and they are used to calculate gross profits as well as gross profit margin.

Before going to the detail, it would be great to show you what you will get after complete this article. and here is the quick check:

Well, once finishing this article, you would be able to 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 not only be able to understand the formula but also know how to calculate the cost of goods sold during the period for your own company as well as the principle behind the formula.

You will gain this by example. Last but not least, you will not only just know what are the factors that affect the cost of goods sold, but also know how to interpret or config the value of COGS.

Now let 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 to find gross profit as well as comparing the gross profit margin of the company to its competitors.

When the gross profit of the company is smaller than its competitors, the current costing system should be further investigated.

And the productions system in term of production efficiency and effectiveness probably are the areas that entity management need to review and assess to see if there any room to improve.

The economy of raw material purchasing is also contributed to the poor performance of gross profit margins.

However, there are other factors that affect the cost of goods sold, for example, the valuation method of inventories, the ending balance, and the beginning balance of inventories.

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We will discuss late this.

Formula:

Cost of Goods Sold for the period: Opening Inventories + Purchase – Closing Inventories

  • Opening inventories are the inventories balance that carrying forward from the previous period. For example, if we are trying to calculate the costs of goods sold during 2020, the opening inventories that we should use to calculate are the inventories balance as of 31 December 2019 or 1 January 2020.
  • Purchasing inventories during the period that we use to calculate the costs of goods sold during the period are the purchasing of 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 inventories balance as of 31 December 2020 is really important. And it is the balance that we should use for calculating the cost of goods sold for the year ending 31 December 2020.

Now, to illustrate the formula above we will provide an example on 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. During the year from 1 January 2020 to 31 December 2020, a purchased 100,000 goods costing $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, there were 50,000 unsold goods 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 and it leads to making a gross profit of 100,000. However, this gross profit might be the effect of the entity uses different inventories valuation methods.

General speaking, inventories valuation method including LIFO, FIFO, and Weight Average Cost and Inventories.

LIFO or Last In First Out is the kind of the valuation method that the ending balance of inventories are valued base on the price of inventories that new purchase or it is assumed that the inventories that the company just purchase are sold and the old inventories remain in stock.

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This is not fair if the product or raw material price significantly fluctuates. This type of method also not allow based on the current accounting standard (IFRS).

Using this method, the ending inventories will be undervalued if the price of inventories purchasing during the period is going up from the beginning and subsequently overstate the Cost of Goods Sold.

FIFO of First In First Out are other types of an inventories valuation method that the cost of inventories will be based on the price of inventories purchase at the end of the period or it is assumed that the inventories are sold in orderly as they purchase.

This method is to make more sense than LIFO and 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 straight forward among the three methods of inventories valuation and the value of inventories is based on the average cost of inventories during the period over total inventories during the period.

To make the calculation more sense, the average cost of inventories should be calculated based on its type.

In conclusion, the Cost of Goods Sold is the direct cost of product that sold during the period and it could be different if different inventories valuation methods are used. The value of ending inventories are different if we use a different method to evaluate.

Is the cost of goods sold presently in the balance sheet?

No, the cost of goods sold is the income statement’s item, and it 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.

What are the critical massages that it tells you?

The cost of goods sold is the direct costs associated with the goods that the company sold to its customers. It is evident that this cost tries to tell the users about the costs that the company spends on the products that they are sold to customers.

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More than that, the costs assist users in assessing the margin that the company could earn from the products comparing the company’s expectations, competitors, and industry averages.

In addition to that, users could initially assess how well the company manages its procurement function in terms of economy, and efficiency and effectiveness of the production process.

The gross profit margin is also calculated by using the cost of goods sold, and after the calculation, users will be able to assess whether or not the entity’s gross profits could handle others sell and administrative expenses.

This is really important for potential investors as they are only want to invest in the company that is profitable.

Key limitation: The number could easily be manipulated: Financial information of the company is really sensitive 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 to competitors or industry averages, management might be considered to 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 is also lead to over or understate the costs.

These accounts are directly associated with the amounts of costs of goods sold. Different cut off between sales and costs for the same products is also lead to over or understate the costs.

These accounts are directly associated with the amounts of costs of goods sold. Different cut off between sales and costs for the same products is also lead to over or understate the costs.