Cost of Goods Sold - Explained
What are Cost of Goods Sold?
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Table of ContentsWhat are Cost of Goods Sold (COGS)?How is Cost of Goods Sold (COGS) Used?Research on Cost of Goods Sold
What are Cost of Goods Sold (COGS)?
Before the end result of any production or manufacturing is attained, funds and other factors of production must be involved. Cost of Goods Sold (COGS) refer to the total costs of the production of goods that a company puts up for sale. COGS is otherwise called 'cost of sales.' Cost of Goods Sold (COGS) is referred to as a managerial and accounting process in which all the direct expenses such as material costs attributed to the production of goods are calculated. Indirect expenses such as sales costs are excluded from COGS.
How is Cost of Goods Sold (COGS) Used?
The expenses of a company during the phase of manufacturing or producing products for sale are captured as Cost of Goods Sold (COGS). These expenses however exclude indirect expenses such as distribution costs of the products after production. Cost of labor or workmanship and cost of materials are examples of direct costs that are attributable to the production of goods. COGS basically captures all the direct costs of goods sold at a specific period of time. It is noteworthy to also state that all the costs incurred on goods that are not sold are not calculated as part of COGS. A balance sheet is a financial statement of a company. Contained in the balance sheet is the inventory. The beginning inventory refers to the amount of stock a company has at the start of the year while ending inventory is the amount left at the end of the year. Cost of Goods Sold (COGS) is calculated by subtracting the inventory at the end of a period from purchases during a period and inventory at the beginning of the period. The formula for calculating COGS is; COGS = Beginning Inventory + Purchases during the period Ending Inventory. Three methods can be used for the calculation of costs of goods sold, the value of COGS is dependent on the method used. The methods are;
- First in, First Out (FIFO)- this means that the first good that was manufactured is sold first. Companies that adopt this method sell least expensive products first which leads to a lower COGS. But with time, net income under FIFO tend to increase.
- Last in, First Out (LIFO) - The last goods that were produced are sold first, this are mostly expensive goods. Higher COGS is recorded in this method but net income tend to decrease as time passes.
- Average cost method - this entails the use of the average price of all the goods in stock in the calculation of COGS.
The calculation of cost of goods sold (COGS) is an essential factor in finding out a company's gross profit. The calculated COGS is subtracted from the revenue of a company to arrive at gross profit. Financial analysts and investors make reference to a company's COGS is evaluating the financial health of the company. COGS is often recorded as a business expense in the income statement of a firm. An increase in COGS translates into a decrease in the net income while in decrease in COGS causes an increase in net income. Despite the importance of cost of goods sold, it still has certain limitations. Its major limitation is that it is subject to manipulations from accountants and managers that want to present false financial reports. COGS can be altered, higher direct costs and manufacturing expenses can be allocated to goods than what they attract in real sense. Overstatement of discounts and returns of supply can also occur. Managers and accountants can also alter or understate an inventory either beginning inventory or ending inventory. In general, COGS faces the risk of being underreported or over- reported as the case may be.