The cost of goods sold includes those costs attributable to the products or services sold by a business. It is usually separately reported in the income statement, so that the gross margin can also be reported. Analysts like to track the gross margin percentage on a trend line, to see how well a company's price points and production costs are holding up in comparison to historical results.
One way to calculate the cost of goods sold is to aggregate the period-specific expense listed in each of the general ledger accounts that are designated as being associated with the cost of goods sold. This list usually includes the following accounts:
- Direct materials
- Direct labor
- Factory overhead
- Freight in and freight out
The list may also include commission expense, since this cost usually varies with sales. The cost of goods sold does not include any administrative or selling expenses.
In addition, the cost of goods sold calculation must factor in the ending inventory balance. If there is a physical inventory count that does not match the book balance of the ending inventory, then the difference must be charged to the cost of goods sold.
An alternative way to calculate the cost of goods sold is to use the periodic inventory system, which uses the following formula:
Beginning inventory + Purchases - Ending inventory = Cost of goods sold
Thus, if a company has beginning inventory of $1,000,000, purchases during the period of $1,800,000, and ending inventory of $500,000, its cost of goods sold for the period is $2,300,000.
To use the periodic inventory system, purchases related to manufactured goods must be accumulated in a "purchases" account.
The calculation of the cost of goods sold is not quite so simple as the general methods just noted. All of the following factors must also be taken into account:
- Charging to expense any inventory items that have been designated as obsolete
- Altering the cost of materials when a different FIFO or LIFO cost layer is used. Alternatively, an average costing method may be used to derive the cost of materials.
- Charging to expense any scrap that is considered abnormal, rather than charging it to overhead
- Charging to expense the difference between standard and actual costs for materials, labor, and overhead
There can also be differences in the cost of goods sold under the cash method and accrual method of accounting, since the cash method does not recognize expenses until the related supplier invoices are paid.
Given the issues noted here, it should be clear that the calculation of the cost of goods sold is one of the more difficult accounting tasks.
The cost of goods sold is also known by the acronym COGS.