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Cost of Goods Sold

The "direct cost" associated with producing any goods or services is quantified by the term "cost of goods sold" (COGS). Direct factory overheads, direct labor costs, and material costs are all included in it, and it directly relates to sales.

The cost of producing the goods or services rises as revenue does, too. Frequently, COGS follows sales revenue as the second line item on the income statement. COGS are subtracted from sales to determine gross profit.

Purpose of Cost of Goods Sold

To determine the "actual cost" of the goods sold during the time period is the main goal of determining COGS. The price of items bought during the period but not sold or just retained in inventory is not reflected. It aids management and investors in keeping track of the company's success.

Limitations of COGS

Accountants or management looking to falsify the accounts can readily modify COGS. It may be changed by:

  1. Applying more production overhead costs into inventory than were incurred
  2. Exaggerating savings
  3. Overstating supplier returns
  4. Changing the inventory in stock amount at the end of an accounting period
  5. Overvaluing current inventory
  6. Failing to discard outdated inventory

Formula and Calculation of COGS

COGS = Beginning Inventory + P āˆ’ Ending Inventory

Where ā€˜Pā€™ = Purchases during the period

Accounting Methods and COGS

The quantity of cost of goods sold depends on the inventory costing methodology a company adopts. A business has three options for tracking the amount of inventory sold over a given time period:

FIFO (First In First Out)

The earliest produced or purchased goods are offered for sale initially. A business that employs the FIFO approach will sell its least expensive products first because prices have a tendency to rise with time, which results in a lower COGS than the COGS reported using the LIFO method. As a result, by adopting the FIFO method, net income grows with time.

LIFO (Last In First Out)

Under the LIFO inventory valuation system, the latest inventory items are sold first. During periods of increasing prices, items with higher costs are sold first, which results in higher COGS and a decline in net income over time.

Average Cost Method

Regardless of when they were purchased, the average cost of all the products in stock is used to determine the value of the sold goods. The smoothing effect of averaging the cost of a product over time avoids COGS from being significantly impacted by the high costs of one or more acquisitions or purchases.

Special Identification Method

The ending inventory and COGS for each period are determined using the special identification method using the exact cost of each unit of product (also known as inventory or goods). A company using this technology is able to pinpoint exactly which product was purchased and at what price. Additionally, this approach is frequently employed in sectors that deal in specialty goods like automobiles, real estate, and rare and expensive diamonds.

Key Takeaways

  • The cost of goods sold includes all expenditures and expenses that are directly related to producing items (COGS).
  • Sales and marketing expenses, as well as overhead costs, are not considered as part of the cost of goods sold.
  • As soon as COGS are subtracted from revenues, gross profit and gross margin are calculated (sales). Higher COGS result in lower margins.
  • The value of COGS can vary depending on the accounting principles used in the calculation.
  • Operating costs (OPEX) are different from cost of goods sold (COGS) because OPEX includes expenses not directly associated with producing goods or services.
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