Explanation of Cost of Goods Sold
As a product moves through the production processes, it will appear on balance sheets as multiple types of inventory. Raw material inventory is the first inventory that contains costs related to the product. As the business manufactures the product, direct material, direct labor, and manufacturing overhead costs will be applied to the product and reflected as work in process inventory. Once the product is complete, the costs related to the product will move to finished goods inventory. Finished goods have completed 100% of the production process but have not yet been sold.
The next step in the process is to sell the product, at which point the costs related to product become the cost of goods sold (COGS), or the total money spent to produce or purchase the products that were sold during an accounting period.
The accountant makes sure that the flow of the product costs is reflected in the general ledger. It is necessary to reflect the costs in the correct inventory account—raw material, work in process, or finished goods—but all inventory accounts are assets located on the balance sheet.
After the product sells, the accountant records the selling price as a credit to revenue and records the means of payment (cash or accounts receivable) as a debit. At this point the accountant moves the costs reflected as finished goods to a different account. Costs will now be reflected as cost of goods sold. COGS is an expense account, and the general entry to this account will be a debit. The accountant enters a credit to the finished goods inventory to reduce the value of that inventory account. The difference between the selling price and the COGS is the profit (or loss) for this particular product (also known as gross profit).
Determining the cost of goods sold (COGS) may seem pretty straightforward. The accountant simply looks at the flow of inventory costs and determines the cost of the inventory that has been sold. For a manufacturing firm, that means taking the balance of the finished goods inventory at the beginning of the period, adding the cost of goods manufactured, and subtracting the finished goods inventory. The cost of goods manufactured (COGM) is the amount spent to produce a product from start through completion and entry into finished goods inventory.
However, there are some options companies have in determining how to maintain costs and apply them to jobs. Different companies handle inventory costs by using FIFO (first in, first out), LIFO (last in, first out), or weighted-average costing. Companies that use weighted-average costing divide the cost of goods available by the number of goods available for sale. If inventory prices vary during the accounting period, then inventory valuation can vary significantly.
Calculation of Cost of Goods Sold
The specific components that make up the cost of goods sold (COGS) calculation are included in the cost of goods sold schedule. This schedule is an internal document that provides information to management. The total amount of the cost of goods sold will be the only part of this schedule that will be included in the external financial statements.
The cost of goods sold schedule starts with the beginning finished goods inventory. This refers to the cost of the products that remained in finished goods at the end of the previous accounting period. Then the accountant adds the cost of goods manufactured during the current accounting period. Calculating the cost of goods manufactured (COGM) uses a separate schedule that includes direct materials, direct labor, and manufacturing overhead. The accountant includes only those products that are 100% complete in the COGM. Adding the beginning finished goods inventory and the cost of goods manufactured provides the cost of the goods available for sale during the accounting period.
The accountant deducts the ending finished goods inventory from the cost of goods available for sale. Doing this provides the cost of goods sold. However, this figure may not accurately reflect the cost of the goods without an adjustment. Because overhead is an estimated amount, it could be either overapplied or underapplied.
- If the overhead is overapplied, then the cost of goods amount will be too high.
- If the overhead is underapplied, then the cost of goods amount will be too low.
Before finalizing the cost of goods calculation, the accountant analyzes the accuracy of the overhead application. Depending on the results of that analysis, the accountant makes the appropriate adjustment to accurately reflect the cost of goods sold.
If overhead is overapplied, then the accountant must deduct it from the unadjusted cost of goods sold. The adjusted cost of goods sold will tie to the figure that appears on the income statement as of the same date, which is usually the end of the quarter or the end of the year. There may also be underapplied overhead. If that occurs, instead of deducting the amount in the schedule, the accountant will need to add the amount to the unadjusted cost of goods sold number.