The account on the income statement called Cost of Goods Sold (abbreviated as COGS) can be confusing to non-accountants. In this article, we’ll attempt to de-mystify it and explain how it works.
Cost of Goods Sold is an account in the Chart of Accounts that is a specific type of expenditure. My old college accounting book defined it as “an expenditure in the ordinary course of business directly related to the production of revenue.” Note that COGS are different than Expenses in that expenses do not relate directly to the production of revenue; they are more related to the operation of the business as a whole.
When purchasing an inventory item for sale, it’s considered an asset (not an expense yet) in the company. When selling an inventory item, the asset is reduced and the Cost of Goods Sold account is increased, moving the item from an asset to the COGS section. It’s no longer an asset once it’s sold, and the cost of the item sold reduces profit and is deducted from the revenue earned to generate Gross Profit.
In the case of wholesale and retail businesses, the cost of goods sold is the amount that was paid for the inventory items to be sold, plus any shipping costs or labor for delivery. In the case of a manufacturer, Inventory (and once sold, COGS) includes the cost of raw materials, labor to produce the item, and sometimes additional allocations of other related costs. Construction businesses may have many COGS accounts, ranging from Direct Labor, Materials, Subcontractor, and Indirect COGS (things like fuel, job supplies, equipment maintenance, etc). Many service businesses do not track Cost of Goods Sold which we at Lucrum feel is a mistake. Taking this shortcut eliminates the opportunity to track profitability by job or customer. For this reason, it’s often worth the few minutes of additional time even for service businesses to use COGS.
At any point in time, the cost of items purchased are in two different accounts:
- The unsold items are reflected in the asset account, Inventory, on the Balance Sheet.
- The sold items are reflected in the Cost of Goods Sold account, on the Income Statement.
It’s important that the Cost of Goods Sold balance is accurate, because Gross Profit is one of, if not the, most important metric for most businesses. Having accurate COGS and Inventory balances also allows for analysis of the health of the company- how fast inventory is selling, days of inventory on hand, and gross margin.
If inventory purchases have not been coded correctly, take a physical inventory count and determine the correct cost of unsold items. If physical inventory does not match the books, an accountant can make a correcting entry between COGS and the Inventory account so that both of them are accurate.
While this primer is helpful for a basic understanding, COGS implementation will vary from business to business. At Lucrum we have experience in many industries and can answer any questions about this or other aspects of cost accounting. Don’t hesitate to reach out.