Introduction to Cost of Goods Sold
The cost of goods sold sometimes abbreviated to COGS or referred to as Cost of Sales, is the costs associated with producing the goods which have been sold during an accounting period. The items must have been sold otherwise there is no cost of goods sold.
COGS can equally refer to a service as well as a physical product hence the uses of the more general term Cost of sales.
Costs Included in COGS
The costs included in COGS are those necessary to bring the product to its present state and condition prior to sale. They do not include selling expenses, distribution costs, marketing etc such costs are termed costs of selling or selling costs or sales and marketing costs.
For a manufacturing, retailing or distribution business the cost of the goods sold refers to the physical product and the costs of bringing it to the point of sale. This might include direct material and labor costs, product costs, purchase returns and allowances, purchase discounts, freight inwards (that is the costs of bringing the product to your place of manufacture or distribution warehouse), and direct labor costs and factory production overhead.
In a services business, the cost of sales is more likely to be wages, salaries and personnel costs for staff delivering the service, or perhaps subcontracting costs. It might include items such as costs of research, photocopying, and production of presentations and reports.
Why is Cost of Goods Sold Important?
In accounting, costs of sales or costs of goods sold are subtracted from sales to calculate gross margin, so the definition of cost of goods sold determines the Gross Margin % of your business and as a consequence important factors such as your Break Even Point.
How do you Record Cost of Goods Sold?
Cost of goods sold is calculated at the end of an accounting period in relation to the items sold during that period.
What you record during the accounting period are your normal accounting costs such as purchases of stock, wages, salaries, factory overheads, carriage inwards. It is only at the end of the accounting period that the calculation of COGS is made. The COGS formula is as follows.
Using a very simple (but unrealistic) example. If you purchase for resale one item at 100 and the carriage costs to deliver the item to your warehouse are 20 then the double entry would be as follows:
| Account | Debit | Credit |
|---|---|---|
| Purchases | 100 | |
| Carriage inwards | 20 | |
| Accounts payable | 120 | |
| Total | 120 | 120 |
At this stage there has been no sale, the costs are simply the costs of purchasing the product and the costs of carriage, you have not recorded cost of goods sold as there have been no sales.
Suppose now the product is sold in the same accounting period for 200, the costs are transferred to profit and loss account via the COGS account as follows:
| Account | Debit | Credit |
|---|---|---|
| Purchases | 100 | |
| Carriage inwards | 20 | |
| COGS | 120 | |
| Total | 120 | 120 |
And the final income statement follows:
| Sales | 200 |
| COGS | 120 |
| Gross profit | 80 |
| Gross Margin % | 40% |
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.