The cost of goods sold is usually the largest expense that a business incurs. This line item is the aggregate amount of costs incurred to create products or services that have been sold. The cost of goods sold is considered to be linked to sales under the matching principle. Thus, once you recognize revenues when a sale occurs, you must recognize the cost of goods sold at the same time, as the primary offsetting expense. This means that the cost of goods sold is an expense. It appears in the income statement, immediately after the sales line items and before the selling and administrative line items.
If there are no sales of goods or services, then there should theoretically be no cost of goods sold. Instead, the costs associated with goods and services are recorded in the inventory asset account, which appears in the balance sheet as a current asset. In actuality, some costs recorded within the cost of goods sold accounts may actually be period costs, and so may not necessarily be directly associated with goods or services, and will not be allocated to them. Also, there may be production-related expenses (such as facility rent) even when there is no production at all, as would be the case when there is a union walkout. In these cases, it is possible for there to be a cost of goods sold expense even in the absence of sales.
The cost of goods sold can vary substantially over time, due to all of the following issues:
- Changes in the purchase price of raw materials
- Changes in labor costs
- Changes in the mix of products sold
- Changes in the costs of overhead allocated to products
- Changes in the method of overhead allocation
- Changes in the inventory layer accessed in FIFO or LIFO costing
- Changes in the amount of scrap and spoilage experienced