Definitions

# Cost of goods sold

Cost of goods sold, COGS, or "cost of sales", includes the direct costs attributable to the production of the goods sold by a company. This amount includes the materials cost used in creating the goods along with the direct labor costs used to produce the good. It excludes indirect expenses such as distribution costs and sales force costs. COGS appears on the income statement and can be deducted from revenue to calculate a company's gross margin.

COGS is the costs that go into creating the products that a company sells; therefore, the only costs included in the measure are those that are directly tied to the production of the products. For example, the COGS for an automaker would include the material costs for the parts that go into making the car along with the labor costs used to put the car together. The cost of sending the cars to dealerships and the cost of the labor used to sell the car would be excluded.

The accounts included in the COGS calculation will differ from one type of business to another.

The cost of goods attributed to a company's products is expensed as the company sells these goods. There are several ways to calculate COGS but one of the basic ways is to start with the beginning inventory for the period and add the total amount of purchases made during the period, and then deducting the ending inventory. This calculation gives the total amount of inventory (the cost of this inventory) sold by the company during the period. Therefore, if a company starts with \$10 million in inventory, makes \$2m in purchases and ends the period with \$9m in inventory, the company's cost of goods for the period would be \$3m (\$10m + \$2m - \$9m).

Subtracting the cost of goods sold from the amount billed when selling the goods (sales revenue) produces the gross profit on the goods.

The net income, what most people understand as the business' income or profit, is determined by subtracting the cost of goods sold and the indirect expenses from the sales revenue.

## Accounting method

This table makes it easy to grasp the concept of cost of goods sold for a merchandising business.

Beginning Inventory \$100 Cost of Goods Purchased \$400
Goods Available for Sale = (\$100+\$400) \$500
Cost of Goods Sold \$300 Ending Inventory \$200

Make a note that the sum of Beginning Inventory and Cost of Goods Purchased is equal to Goods Available for Sale, and so is the sum of Cost of Goods Sold and Ending Inventory.

Cost of goods purchased is calculated as follows. Purchases minus Purchases returns and allowances and minus Purchases discounts gives us Net Purchases. Net Purchases plus Freight-In gives us Cost of Goods Purchased.

Cost of Goods Sold is calculated by subtracting Ending Inventory from Goods Available for Sale.

The revenue from merchandise sold must be matched with the COGS. Cost of sales or cost of goods sold is the identification of the cost of those items sold in the most recent accounting period. It can be done by specific identification, taking inventory, or different methods using estimates such as the "retail" method.

COGS is also the determining factor in arriving at gross profit and in a manufacturing business is determined under the periodic method as follows:

```Sales--------------------------------- \$100,000
Cost of Goods Sold
Inventory 01/01/03-- \$ 5,000
Purchases------------ 45,000
Direct Labor--------- 30,000
_______
80,000
Less: Inventory 12/31/03----- 10,000
_______ Net Cost of Goods Sold---------------- 70,000
______Gross Profit on Sales------------------ \$30,000
```

To determine the net profit, one would then compute the indirect expenses such as office expenses, light, heat, etc. Determining the cost of goods sold is the first step in arriving at the net profit.

If the COGS is too high, then the gross profit will not support the indirect expenses and the result will be a loss for the accounting period.

Cost of Goods: the price paid for the product, plus additional costs necessary to get the merchandise into inventory and ready for sale, including shipping and handling. It can also be defined as the difference between the goods available for sale and the ending inventory. It indicates the cost of the goods sold during the period. The direct costs attributable to the production of the goods sold by a company, this amount includes the cost of the materials used in creating the good along with the direct labor costs used to produce the good. It excludes indirect expenses such as distribution costs and sales force costs. COGS appear on the income statement and can be deducted from revenue to calculate a company's gross margin. Investopedia Says: COGS is the costs that go into creating the products that a company sells; therefore, the only costs included in the measure are those that are directly tied to the production of the products. For example, the COGS for an automaker would include the material costs for the parts that go into making the car along with the labor costs used to put the car together. The cost of sending the cars to dealerships and the cost of the labor used to sell the car would be excluded.

The exact costs included in the COGS calculation will differ from one type of business to another. The cost of goods attributed to a company's products are, expensed as the company sells these goods. There are several ways to calculate COGS but one of the more basic ways is to start with the beginning inventory for the period and add the total amount of purchases made during the period then deducting the ending inventory. This calculation gives the total amount of inventory or, more specifically, the cost of this inventory, sold by the company during the period. Therefore, if a company starts with \$10 million in inventory, makes \$2 million in purchases and ends the period with \$9 million in inventory, the company's cost of goods for the period would be \$3 million (\$10 million + \$2 million - \$9 million). There are several types of cost classification. Depending on what a particular business needs will depend on what Cost Accounts they need. Some companies will enlist several different accounts and others will use very few. The following classifications help determine needed information as well as helping a business in determining how much they are going to sell a product or service. This information is needed in order to determine what would be needed in order to cover their cost manufacturing a product or selling a service as well as determining how much profit they wish to obtain. A basic break down in determining classification of cost, would be determining if Cost is fixed or variable. A fixed cost is defined as a cost that doesn’t change. Variable cost, on the other hand, changes as needed in order to keep up with the volume of product. Once an individual has an understanding of the differences between the basic classification types we can then present a new classification. Some costs are considered Mixed, meaning they are both fixed and variable. An example of a fixed cost would be a monthly rent payment. The only time this amount changes is when a renter signs a new lease agreement, otherwise the rent remains the same for the life of the contract signed. An example of a variable cost would be similar to filling an automobile with gas. As the price of gas increases or decreases, the amount an individual pays in order to fill his or her car will increase or decrease. Lastly, an example of a mixed cost would include something like a truck rental. It costs an individual so much for the first hour and then a separate amount for any time after that initial hour. We next move on to classification by traceability, this means that Cost will be dependent on the cost of the product, department, and even includes the customer that the cost is assigned. There are two classifications used in determining this information, direct cost and indirect cost. Direct cost is defined as those cost that can be traced to its cost object. An example of direct cost would be material and labor cost. Indirect cost is defined as a cost that cannot be traced to a single cost object. An example of indirect cost would include a maintenance plan that affects two or more departments. The next type of classification that we will discuss is called Cost by Controllability. This classification is a bit easier to understand because it includes cost that can or cannot be controlled. This classification usually has to do with the management of the company and each component involved is assigned to a specific group of people. Examples of each of these include investments in machinery of controlled, and the cost of running a business for not controlled. The fourth classification in determining cost is classification in relevance. This classification determines if the cost is to be a sunk cost, or an out of pocket cost. A sunk cost is something that doesn’t relate to future planning, it is something that has already been paid for and will not have to be paid for again. An out of pocket cost is something that the company pays for on a regular basis. This type of cost does play a part in financial planning for the company. The last classification that will be discussed is classification by function. What is the cost for? Usually this cost classification is a breakdown of the cost of manufacturing a product. This cost allows manufacturing companies to determine how much a given product will be sold for. This cost helps to determine what needs to be charged in order to cover the manufacturing cost as well as making a profit.

Computation of gross profits with COGS highlighted

```Sales---------------------------------------------------------- 113,000.00
Less sales returns and
Allowances-----------------------------------------------------     800.00
Net sales----------------------------------------------------------- 112,200.00
Cost of goods sold:
Merchandise, Jan 1-------------------------------- 34,000.00
Purchases----------------------- 76,000.00
Returns and
allowances------ 4,000.00
Purchase
Discounts------- 3,000.00
Less: Purchases-------------  7,000.00
Net purchases---------------------------- 69,000.00
Cost of goods
purchased---------------------------------------- 70,500.00
Goods available for sale--------------------------------------- 104,500.00
Less merchandise inventory,
Dec. 31-------------------------------------------------------- 30,000.00
Cost of goods sold--------------------------------------------------- 74,500.00
Gross profit------------------------------------------------------------- 37,700.00
```