Definition of Cost of Goods Sold
The Cost of goods sold is the total cost of the goods produced or sold or the total cost of services rendered, which includes direct labor costs, overhead costs, direct material costs, payroll taxes, and other related costs; in other words, it is the total cost which is incurred in the production of goods or services that is incurred directly in bringing the goods on its point of sale, and it is an important aspect which is used while calculating the gross profit.
The C.O.G sold is the total cost directly incurred in bringing the goods to their point of sale. In the Profit & Loss account, there are two parts. In the first part, we calculate the gross profit in which we take total income and deduct all the costs that are directly incurred in the production of those goods and in the second part, we calculate net profit, in which case we deduct all the indirect costs that are not directly incurred in the production of goods from the gross profit, and thus we get the net profit. Hence, all the identifiable costs directly incurred in the production of goods constitute the C.O.G Sold.
The most important purpose of C.O.G is its requirement for the calculation of the gross profit of the company in the company’s profit and loss account. In the Profit and loss account, there are two parts, the first part of which includes the costs which are directly related to the production of the goods sold and the second part in which the cost that are not directly related to the production of the goods sold, i.e., indirect costs are included With the help of first part, gross profit is calculated and second part helps in the calculation of net profit. Hence, the Cost of goods sold helps in the calculation of gross profit, which is the measure of evaluating the company’s efficiency in managing its labor and supplies in the production process. The cost of goods sold is inverse to the company’s income.
Formula for Cost of Goods Sold
The Formula for calculating the C.O.G sold is:
Let’s consider Company XYZ Ltd. which is the manufacturing company in the field of Coal. It has an opening inventory at the beginning of the year of $15,000. Its Inventory during the end of the year is $7,000. During the entire year, it has made purchases of $9,000. In this case, the C.O.G sold is calculated as:
C.O.G is calculated as:
Cost of Goods Sold = (Opening Inventory + Purchases – Closing Inventory)
- C.O.G sold = ($15,000 + $9,000 – $7,000)
- C.O.G sold = $17,000
What Includes in Cost of Goods Sold?
The following costs are included in the C.O.G sold:
- Cost of purchase of a product or its parts.
- Cost of Purchase of the raw material of the product.
- Direct Labor Cost paid for the production of goods or rendering of services.
- Storage Costs
- Shipping charges and freight charges
- Machinery Costs or other production equipment cost
- Warehousing cost
- Other Overhead costs.
Accounting for Cost of Goods Sold
There are four methods of accounting for the C.O.G sold:
- First-in-First Out (FIFO): In the FIFO method of accounting, the costs which are incurred first are taken into account for the calculation of COGS.
- Last-in-First Out (LIFO): Contrary to the above, in the LIFO method of accounting, the costs incurred in the later time period are taken into consideration in the calculation of the C.O.G sold.
- Weighted Average: In this method of accounting, for calculating the C.O.G sold, the total cost of the goods available for sale is divided by the number of goods sold.
- Specific Identification: In this method of accounting, the specific costs that are attributable to the unit sold are taken into consideration as the C.O.G sold. These are the identifiable costs that are product-specific.
The Journal Entry for recording C.O.G Sold:
|Cost of goods sold A/C Dr||$|
|To Purchases A/c||$|
|To Inventory A/C||$|
The following are the benefits of the C.O.G sold:
- The calculation of the C.O.G sold gives an accurate and more specific calculation for the valuation of inventory. We get a clear picture of the inventory costs and hence can have better inventory classification too.
- As the cost of inventory valuation is clearly defined, it helps the enterprise in the proper future prediction of the costs and also the other costs that it can afford.
- We get to know the time period of the inventory purchase too, i.e. we can get the idea as to which inventory is the latest one and which is the most updated inventory.
- The C.O.G Sold helps the enterprise in the calculation of gross profit. The gross profit helps to measure the efficiency of the enterprise in terms of its labor and other supplies. Hence Cost of goods sold helps the enterprise in evaluating its labor and other supplies’ cost efficiency.
The following are the disadvantages of the C.O.G Sold:
- Generally, the C.O.G sold reflects the purchase cost of the materials. i.e. the historical cost of the materials. Hence, it does not take the current market value of the material.
- The costs of the materials and other things used in the process of production keep on fluctuating due to the market effect. Hence, we do not get the estimation of the real cost that is updated. Hence, the true picture of the cost sheet is not reflected properly considering updation as per the market conditions.
The C.O.G sold helps in the valuation of inventory and inventories are at last converted into profits. The C.O.G sold helps to track the overall costs which are essential for calculating tax purposes and profit margins. Hence, this helps the enterprise with proper planning for future projects or for future predictions.
This is a guide to Cost of Goods Sold. Here we discuss the definition and purpose of the cost of goods sold along with its advantages and disadvantages. You may also have a look at the following articles to learn more –