What is Cost of Goods Sold? Definition from WhatIs com

In addition to COGS, there are a few other formulas businesses will need to use to understand their overall profitability and business health. Additionally, COGS can’t be helpful if it’s calculated using inaccurate data. If you’re simply trusting the inventory numbers in your records, those numbers could be off, which would make any COGS value calculated using those numbers off as well.

For example, let’s say a construction business is using COGS but 75% of the Revenue is on the balance sheet as a deposit liability. They will finish the job and the Revenue will be recognized in the following month. This would mean all of the costs would be recorded in months 1 and 2, but the Revenue would be recorded in month 3. Both must hit the PL at the same time or the monthly Gross Profit $ and Margin % will be very difficult to track.

Accounting for Cost of Goods Sold

In the case of a manufacturer, Inventory (and once sold, COGS) includes the cost of raw materials, labor to produce the item, and sometimes additional allocations of other related costs. Manufacturing businesses must also calculate yield, something most other businesses don’t. For example, buying a sheet of steel might bank reconciliation statements cost $130 dollars and make 3 widgets. Most manufacturers do the $130/3 match and count any scrap value as “free” and don’t factor it into the cost. When running a business, it is important to track expenses, income, and the flow of money. This allows the business owner to know how well their business is performing.

An expense account in accounting contains the cost of doing business. In theory, COGS should include the cost of all inventory that was sold during the accounting period. In practice, however, companies often don’t know exactly which units of inventory were sold. Instead, they rely on accounting methods such as the first in, first out (FIFO) and last in, first out (LIFO) rules to estimate what value of inventory was actually sold in the period.

What type of account is cost of goods sold?

Imagine that you are the owner of a business that sells electronics. You make electronic gadgets that people love such as a watch that tells you when it’s going to rain so you’ll always know when you need to bring an umbrella. All of this is recorded on your financial statements that you keep for your quarterly earnings statements to your stockholders as well as for your annual taxes. On your financial statements, you notice that your cost of goods sold is a separate line from your expenses line.

Indirect COGS still relate to the production of revenue, but cannot be tied to a specific customer, job or project (at least not easily). For example, fuel, is an indirect cost of performing a job or service; it would be really difficult to allocate each gallon of fuel to a specific project or job. LIFO, or the “last-in-first-out” method, assumes that the last goods that are purchased or produced are the first to be sold. In other words, the newest inventory is the first to leave the warehouse and get shipped to the customer. FIFO, or the “first-in-first-out” method, assumes that the first goods that are purchased or produced are the first to be sold. In other words, the oldest inventory is the first to leave the warehouse and get shipped to the customer.

Difference between COGS and Expense

If a business isn’t hitting its target Profit ($) or Margin (%) it’s very hard to cut operating expenses to make up the difference. That small % might sound trivial, but it could equate to 100s of thousands of dollars in additional cash and profit if they were hitting it. This refers to the amount of sellable inventory that your business has left at the end of a given reporting period. As such, it has an impact on your balance sheets and your taxes, making it an important metric to calculate. Assuming prices go up over time, a LIFO business sells its most expensive products first.

To get the value of your inventory at the beginning and end of the year, you may need to do some kind of physical (or electronic) inventory. Check with your tax professional for help on the best way to get an accurate count. Get instant access to video lessons taught by experienced investment bankers.

How Do You Calculate Cost of Goods Sold (COGS)?

Within your first quarter, your business buys the materials to make 10 tapestries. At the beginning of the quarter, it cost $50 to make each tapestry, and you made 7 tapestries. But over time, the price of the raw materials goes up, and the last 3 tapestries you make in the quarter cost $80 each to make. Cost of revenue refers to costs paid for contract services, such as labor services or sales commissions. In order for these costs of revenue to count as COGS, the IRS dictates that services rendered must produce a physical product that is sold. For tax purposes, businesses must use COGS to calculate what it owes.

Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts. The difference lies in the useful life, as it can take several years to derive the benefits from CapEx/fixed assets (e.g. purchase of machinery). Our post on “Cost of Goods Sold vs. Operating Expenses” will focus on the differences between the two types of costs, but we’ll start with the similarities.