The figure for the cost of goods sold only includes the costs for the items which are sold during the period and not the finished goods which 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 that occurred on other than the production process or are indirect to the production of finished products and that 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 the value of it before we process a journal entry. This can be found by the following COGS formula
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 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 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 the inventory valuation is completed by any of the above methods, 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 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 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 compliance with the matching principle which will result in the over or understated of 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, it gives us the following:
COGS = $500 + $200 – $300
COGS = $400
Let’s say a further direct cost of $200 is incurred on labor, this gives us a total cost of goods sold of $600 ($200+$400). In other words, the total finished goods that were sold is $600.
Therefore, the double entries for this is as follow:
Dr Cost of goods sold $600
Cr Finish goods $600
Debited to cost of goods sold amount $600 will result increase 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 at price $1,000 on credit, then the entries for sales transactions that correlated with this goods is
Cr Sales $1,000
Dr Account receivable amount $1,000