The cost of goods sold is the direct costs incurred on the production of items manufactured and then sold. Costs of goods sold only include the directly associated costs of inventory and labor.
The figure for the cost of goods sold only includes the costs for the items sold during the period and not the finished goods that are not still sold or billed by customers. Costs of goods sold vary as the number of finished products increase or decreases.
Costs of goods sold do not include other materials or labor costs other than the production process or are indirect to the production of finished products and do not vary with the quantity of finished stock produced.
Below is the explanation of how the cost of goods sold is recorded in the form of double entries in the company management account or financial statements.
Accounting for costs of goods sold in financial statements:
To record the cost of goods sold, we need to find its value before we process a journal entry. The following COGS formula can find this.
Cost of Goods Sold = Beginning inventory + Purchases – Closing Inventory
This COGS formula, when adjusted with the corresponding figures, gives a final figure for the cost of goods sold. However, before passing a journal entry, this is necessary to find the value of inventory consumed.
Inventory consumed can be valued by many different methods. These are the first in, first out, weighted average cost method, and specific identification method. These are briefly defined below:
First in First Out Method of Valuation:
First in, the first out method values inventory at the earliest value of inventory. The cost of goods sold is measured according to the prior inventory purchased rather than the recent one.
Weighted average cost method of Valuation:
The weighted average cost method measures the value of the cost of goods sold and closing inventory at a rate such that the cost of total inventory purchased is divided by the total units in the inventory.
Specific Identification method:
In this method of valuation of inventory, the company values the cost of goods sold and closing inventory at a specific cost specially identified for a specific product. These are feasible in only certain industries such as car manufacturers, real estate businesses, furniture, and other on-demand manufacturers industries.
Journal entry for cost of goods sold:
Once any of the above methods complete the inventory valuation, it should be recorded by a proper journal entry. Once the inventory is issued to the production department, the cost of goods sold is debited while the inventory account is credited.
As the cost of goods sold is a debit account, debiting it will increase the cost of goods sold and reduce the company’s profits. The inventory account is of a debit nature, and crediting it will decrease the value of closing inventory. The cost of goods sold is also increased by incurring costs on direct labor.
Here is the entry when the goods are sold,
Dr Cost of goods sold
Cr Finish goods
As explained, the debit cost of goods sold will increase the cost of goods sold in the income statement, and credit to finish goods will decrease the balance of finished goods in the balance sheet.
Recognition of cost of goods sold and derecognition of finished goods (Inventories) should also be consistent with the recognition of sales. If it is not consistent, then the cost of goods sold and revenues will be recognized in the financial statements in a different period. And it is not in compliance with the matching principle, resulting in the over or understated profit during the period.
Let’s suppose a company has an opening inventory of $500, further purchases of $200 are done, and the closing balance at the yearend is $300. These figures, when carried in the above formula, gives us the following:
COGS = $500 + $200 – $300
COGS = $400
Let’s say a further direct cost of $200 is incurred on labor, and this gives us a total cost of goods sold of $600 ($200+$400). In other words, the total finished goods that were sold was $600.
Therefore, the double entries for this are as follow:
Dr Cost of goods sold $600
Cr Finish goods $600
Debited to cost of goods sold amount $600 will result in an increased cost of goods sold in income statement amounted to $600. This will decrease gross profit. And finish goods balance at the year ended will be decreased $600. Assuming the goods were sold for $1,000 on credit, then the entries for sales transactions that correlated with these goods are:
Dr Account receivable amount $1,000
Cr Sales $1,000
Is cost of good sold debit or credit?
The nature of the cost of goods sold is an expense and is recorded in the income statement of the company during the period goods are sold. Increase of it are recording debit and decrease of it are record in credit. The contra entry of cost of goods sold is normally the inventory.