NEVER MISS – This Is How Cost of Goods Sold Is Calculated

Even though many of us are well conversant with Cost of Goods Manufactured and Cost of Goods Sold, many still ask me how cost of goods sold is calculated and what is the crucial difference between these two accounting terms. Cost of Goods Manufactured and Cost of Goods Sold are the most discussed topics in the cost accounting terminology. Today, I have taken the responsibility to make you well understand about these two most used accounting terms in manufacturing industries with their accounting and reporting aspects.

Besides, every business entrepreneur must know how his company made the profit from sales. In order to understand and ascertain the profit, he needs to know Cost of Goods Sold as it plays an important role in understanding the profit. At first we will learn the terms and then discuss their accounting and reporting issues.

What is Cost Of Goods Sold (COGS)?

Cost of Goods Sold (COGS) is simply refers to the direct costs incurred and attributable to a product produced that is later sold by a company. It doesn’t reflect the cost of goods that are purchased or produced during the period and not being sold or just kept in inventory. Generally, it is the cost, in selling point, of a product offered to a distributor or retailer. It includes the expenses that have been incurred to produce the finished product that the company sells. It includes direct material cost, direct labor cost and overhead. To know more on how Cost of Goods Sold is calculated, you should follow the full article.

Any supplies not used directly to manufacture a product are not included in Cost of Goods Sold (COGS).  Again, it does not include general selling expenses, such as management salaries and advertising expenses. COGS is directly proportional to sales revenue. The higher is the COGS the lower is the gross profit.

The 3 Components of Cost of Goods Sold

There are 3 main components of COGS: Direct materials, Direct Labors and Factory Overhead. Material is calculated net of materials after freight-ins, returns and discounts. Factory overhead may be fixed or variable or both. COGS generally includes the following:

• Raw materials purchased for production or resale
• Freight-in costs or landed costs like duties, insurance, freight etc.
• Purchase returns and allowances, trade or cash discounts received on purchase
• Holding costs i.e. warehousing, insurance, interest etc.
• Direct labor used in production
• Expenses or overheads used in production i.e. production salary, utility, repair and maintenance, etc.
  

How Cost of Goods Sold is Calculated

The popular cost of goods sold formula is: COGS=Opening Inventory + Purchases – Ending Inventory. This formula you have seen in exam solutions or reporting but may not express you complete sense as to how Cost of Goods Sold is calculated unless a practical example is given. Because in some situations Cost of Goods Sold and Cost of Goods Manufactured are same and create confusions among users. Let’s have a look on the image below and see the transactions and inventory balances.

Cost of Goods Sold (COGS) is related with the sales point while the Cost of Goods Manufactured is related with manufacturing point. But when sales point and manufacturing point is one and the same location, then what? We will assume some manufacturing scenarios for better understanding.

There are generally 3 sequential stages of inventory when a production process is carried on:

(1) Raw materials stage when materials are bought for production , then

(2) Work-in Process stage, when materials follow a conversion process to get turned into finished goods

(3) Finished Goods that will be sold to distributors or retailers

These 3 sequential stages will be used to fully explain how Cost of Goods Sold is calculated. The first one (Raw Materials) will be used as the input for the second ( Work-in Process) and the second one ( Work-in Process) will be used as the input for the third (Finished Goods). Each Stage has it’s own receipt, issue and closing balance. Receipts will denote all receipts from previous stages while Issues will denote transfers to (a) Sales next stage or for sale. Let’s have some scenarios.

Scenario-1:

Luminata Limited has Materials of $5000 at the beginning on January 1, 2022. It purchased materials of $4000 in January 2022. So, the available material is of $9000 now, before they are used in production/sales. Say, in the middle of January a surprise stock take is conducted by the Management and found the material of $2000 only in the stock. Where is the remaining stock of $7000 now? Simply issued for (a) sale or (b) for production (think no mismanagement happened).

The place of (a) is selling point [in case of trading business], so here $7000 will represent COGS but the place of (b) is manufacturing point [in case process organizations], so here $7000 will represent issued to production (WIP).

• Beginning Inventory (materials): $5,000
• Purchases (materials): $4,000
• Ending Inventory (materials): $2,000

The place of (a) is selling point [happens in trading business], so here $7000 will represent COGS

Cost of Goods Sold = Beginning Inventory + Purchases – Ending Inventory

COGS =$5000+$4000-$2000=$7000

The place of (b) is manufacturing point [happens in process organizations], so here $7000 will represent materials Issued to production (WIP).

Materials Issued to production (WIP) = Beginning Inventory + Purchases – Ending Inventory

Materials Issued to production (WIP) =$5000+$4000-$2000=$7000

In the rest of the explanation, I will go with Manufacturing thoughts.

Scenario-2: Emergence of Cost of Goods Manufacturing (COGM):

Say, Luminata Limited is a full fledged manufacturing organization. It is now in Day-1 of production on January 1, 2022, so it doesn’t have any Work-in Process at the Beginning. It has received materials of $7000 from the store in the middle of the month, which was shown in the Scenerio-1, in order to produce finished goods that will be sold to distributors or retailers.

Say, the conversion costs (i.e. labor $100 & Overhead $300) to produce the finished goods is $400 and at the end of the month no WIP is found in the production floor . Then where is the production, now? Think simply, they are transferred to FG Warehouse leaving WIP zero. This is the place where Cost of Goods Manufacturing (COGM) emerges.

• Beginning Inventory (WIP): $0
• Received materials from Store for Production: $7,000
• In Process Conversion Costs ( direct labor + overhead): $400
• Ending Inventory (WIP): $0

Cost of Goods Manufactured= Beginning Inventory + Received materials from Store for Production – Ending Inventory

COGM =$0+$7400-$0=$7400

Scenario-3:

Say, Luminata Limited has received Finished Goods worth $7400 from the production floor [green zone in this example and picture] in it’s FG Warehouse and it doesn’t have any opening stock. It may have:

Option (1) to sell them from the Warehouse 1 location itself [selling point 1, in this example and picture]. Here, no extra cost will be incurred. So, say 100% FG is sold. Thus, here, Cost of Goods Sold ($7400) and Cost of Goods Manufactured ($7400) are same. Or,

Option (2) send them to Warehouse 2 location [selling point 2, in this example and picture]. Here, some $100 extra cost will be incurred for distribution to Warehouse 2. So, say 100% FG is sold. Thus, here, Cost of Goods Sold ($7400+$100=$7500). If Luminata Limited has policy to expense out the distribution cost, then still Cost of Goods Sold is $7400.

Cost of Goods Sold = Beginning Inventory (FG) + Received from Production – Ending Inventory (FG)

Accounting for Cost of Goods Sold

Before summarizing how Cost of Goods Sold is calculated we can have a look how it is treated in accounting world. There are different policies laid down by IFRS, IAS and US GAAP, for accounting for COGS and inventory. The four main valuation methods for inventory and cost of goods sold are mentioned below:

1. First-in-first-out (FIFO)
2. Last-in-first-out (LIFO)
3. Weighted average
4. Specific identification

Under First-in-first-out (FIFO), COGS consists of finished inventory units that were produced first and thus consist of costs incurred first, whereas under Last-in-first-out (LIFO), COGS consists of finished inventory units that were produced last and therefore consists of later or most recent costs. LIFO is allowed under U.S. GAAP but it is no longer allowed under IFRS. The argument is it allows companies to defer taxes on real gains when the prices of their goods are rising relative to general prices.

Reporting of Cost of Goods Sold & Cost of Goods Manufactured

This Is How Cost of Goods Sold Is Calculated and Reported

Salient Features of Cost of Goods Sold

• It appears when a sale happens.
• It includes direct materials, direct labor and overhead incurred to produce the finished product that the company sells.
• It doesn’t reflect the cost of goods that are purchased or produced during the period and not being sold or just kept in inventory.
• Any supplies not used directly to manufacture a product are not included in Cost of Goods Sold
• It does not include general selling expenses, such as management salaries and advertising expenses.
• It is directly proportional to sales revenue.
• The higher is the COGS the lower is the gross profit.

Salient Features of Cost of Goods Manufactured

• It happens in WIP stage of production where conversion takes place.
• It is the total cost ( material + labor + overhead) of transfers of all products from production floor to FG Warehouses during a period.

Purpose of Cost of Goods Sold

Cost of Goods Sold is a true determiner how a company wants to show it’s bottom line of the income statement. It has a dominant role in product pricing. Every business must find ways to lower it’s costs in all aspects to be present in the business. Better negotiations, better terms with suppliers, introducing less expensive materials without compromising quality, comparing with industry trends, or other measure may show some ways to control the COGS.

Conclusion

I hope you have already learnt the part and parcel of how Cost of Goods Sold is calculated, accounted and reported in financial arena. If you liked the article, please share it to spread the knowledge.