Understanding Cost of Goods Sold

Understanding Cost of Goods Sold

Cost of goods sold (COGS) refers to the total amount of cost that a company has spent in creating a product or a service that it has sold. Business owners should divide these costs into a few sub-categories, which are materials, direct labour, as well as overhead. For a company that offer services, the business owner should take the labour, payroll taxes as well as the benefits of the people who help in generating billable hours as its cost of goods sold (Also see Should You Include Cost of Goods Sold (COGS) as Expenses?). On the other hand, for a company that runs a retail business, the business owner should consider the goods that he has purchased from a manufacturer as the cost of goods sold.

Do you feel confused now? Accounting tasks that involve the cost of goods sold is not something easy to handle. If you are running a small business and cannot afford to employ a full-time accountant for your company, why don’t you seek help from an accounting firm in Johor Bahru? Calculating the cost of goods sold correctly is crucial for every company as it helps business owners to know the profitability of their business. This is because they can calculate the company’s gross margin, which can show the sum that the business has earned from selling its goods and services, by deducting the cost of goods sold from net sales (Also see Can You Differentiate Net Income and Net Sales?) when presenting the income statement.

If a company uses the periodic inventory system (Also see Periodic Inventory System and Perpetual Inventory System), it may calculate its cost of goods sold by adding up the number of inventories from the beginning and its purchases, then deduct its ending inventories from the amount calculated. This is because we can assume that by doing this calculation, the result that shows the costs that are no longer in the warehouse should be relevant to the products that the company has sold. Also, this calculation takes obsolete and scrapped inventories which have been removed from the warehouse into consideration. Hence, this calculation assigns too many expenses to the goods that the company has sold, but in fact, these costs are more relevant to the current accounting period.

If the system that a company uses is the perpetual inventory system, the company needs to compile the cost of goods sold continuously as time passes as the company sells the goods to its clients. Using this approach means that the company needs to record a lot of different transactions, for example, obsolescence, scrap, sales, and so on. If the company uses cycle counting to ensure the accuracy of the records the workers have made, then compared to the calculation of the cost of goods sold under periodic inventory system, the perpetual system tends to show a more accurate result.

The costing approach that the company uses to calculate its ending inventory costs will have an impact on the cost of goods sold. Listed below are two inventory costing approaches, which are first-in, first-out (FIFO) and last-in, first-out (LIFO), as well as their impacts:

Last-in, first-out (LIFO)

If a company uses this method, the last unit that it has added to its inventories will be presumed as the one that it will use first. Hence, it tends to charge the higher-cost goods to the cost of goods sold in an environment with increasing prices where inflation happens.

First-in, first-out (FIFO)

If a company uses this method, the first unit that it has added to its inventories will be presumed as the one that it will use first. Hence, it tends to charge the lower-cost goods to the cost of goods sold in an environment with increasing prices where inflation happens.

In some cases, the company may change the cost of goods sold fraudulently to alter the profit levels reported. It may do so in many ways, for example, it may count the inventories that it has on hand wrongly, allocate higher overhead than the actual amount to its inventories, or change the bill of materials or the labour routing records.

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