Accounting Dictionary

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Cost of Goods Sold

Definition: Cost of goods sold is the accumulated total of all costs used to create a product or service, which has been sold. These costs fall into the general sub-categories of direct labor, materials, and overhead. In a service business, the cost of goods sold is considered to be the labor, payroll taxes, and benefits of those people who generate billable hours (though the term may be changed to "cost of services").

In the income statement, the cost of goods sold is subtracted from revenues to arrive at the gross margin of a business.

The cost of goods sold is calculated as beginning inventory + purchases - ending inventory. The assumption is that the result, which represents costs no longer located in the warehouse, must be related to goods that were sold. Actually, this cost derivation also includes inventory that was scrapped, or declared obsolete and removed from stock, or inventory that was stolen. Thus, the calculation tends to assign too many expenses to goods that were sold.

The cost of goods sold can also be impacted by the type of costing methodology used to derive the cost of ending inventory. Consider the impact of the following two inventory costing methods:

• First in, first out method. Under this method, known as FIFO, the first unit added to inventory is assumed to be the first one used. Thus, in an inflationary environment where prices are increasing, this tends to result in lower-cost goods being charged to the cost of goods sold.
• Last in, first out method. Under this method, known as LIFO, the last unit added to inventory is assumed to be the first one used. Thus, in an inflationary environment where prices are increasing, this tends to result in higher-cost goods being charged to the cost of goods sold.

For example, a company has $10,000 of inventory on hand at the beginning of the month, expends $25,000 on various inventory items during the month, and has $8,000 of inventory on hand at the end of the month. What was its cost of goods sold during the month?  The answer is:

The cost of goods sold can be fraudulently altered by a number of means in order to change reported profit levels, such as:

• Altering the bill of materials and/or labor routing records in a standard costing system
• Incorrectly counting the quantity of inventory on hand
• Performing an incorrect period-end cutoff 
• Allocating more overhead than actually exists to inventory