Account for Cost of Goods Sold

The cost of goods sold (COGS) for a period is the total amount of costs involved in manufacturing a product or delivering a service. COGS varies for products and services, but it generally includes labor, materials and overhead. On your company’s income statement, the COGS is subtracted from the total revenues to calculate the gross profit margin. In broad terms, you calculate COGS by determining the amount of inventory used in the period. This assumes that the inventory used in that period was used to produce what was sold in the same period.

Steps

Calculating Beginning Inventory, Costs and Purchases

1. Determine the beginning inventory value. This should always be the ending inventory value from the previous reporting period. If you are a retailer, this number will consist of the cost of all the merchandise in your stock that you plan on selling to customers. If you are a manufacturer of goods, this number will consist of three kinds of inventory: raw materials (all of the materials used to manufacture the product); works-in-progress (items that are in process but aren’t completely finished); and finished goods (completed products that are ready for sale).
   • For this example, assume the ending inventory value from the previous period was $17,800.
2. Add the value of all inventory purchases. This figure can be obtained by adding up the amounts from each invoice for products received during the month. Products received, but not yet invoiced from the vendor, should be priced according to the purchase order. If you are a manufacturer, this includes the cost of all raw materials purchased for manufacture into a finished product received during this recording period.
   • Assume your total raw material purchases total $4,000 and finished product inventory purchases for the period are $6,000 for the purpose of this example.
3. Calculate the labor costs involved for manufacturing the goods. Including indirect and direct labor costs to calculate cost of goods sold only applies to manufacturing and mining companies. Calculate the wages and salaries of all manufacturing employees plus the cost of their benefits. Typically, wholesalers or resellers will not include the cost of labor in this figure, as it cannot be properly charged to the "cost" of the goods.
   • For manufacturers, include all direct labor (those employees directly involved with building merchandise out of the raw materials) and indirect labor (employees who serve a necessary factory function, but not one directly involved with the manufacturing of goods). Administrative expenses are not included.
   • For this example, manufacturing labor costs of $500 per person x 10 people for this period were $5,000.
4. Account for materials, supplies, and other costs of manufacturing. For manufacturers only, containers, the cost of freight, and the cost of overhead expenses like rent, heat, light, power, and other expenses associated with keeping manufacturing facilities open can be included in this figure. Add these numbers together to determine the Cost of Goods Available (beginning inventory, purchases and manufacturing labor costs).
   • Note that overhead expenses for the manufacturing area only can be allocated to this calculation. This includes rent, utilities and other expenses for the manufacturing area. Similar expenses for other areas in the business, such as the office area, are not directly related to manufacturing the product. So these overhead expenses are not included.
   • For example, include other manufacturing costs such as freight-in of $1,000, containers for raw materials of $500, and overhead costs attributed to manufacturing such as heat and lights of $700. The total miscellaneous costs = $2,200.
5. Calculate the Cost of Goods Available. This is the number from which you'll subtract the ending inventory to determine the COGS. For example, $17,800 (beginning inventory) + $10,000 (purchases) + $5,000 (manufacturing labor costs) + $2,200 (miscellaneous costs) = $35,000 Cost of Goods Available.

Calculating Ending Inventory

1. Choose from two methods to estimate the ending inventory. You might need to estimate the ending inventory because it’s too difficult to calculate the exact value. This could happen because of a surge of shipping activity at the end of the period, or if the staff is unavailable to do a physical count of inventory. These methods rely on historical trends, so they are not 100 percent accurate. However, if your company hasn’t had any abnormal transactions during the period, you could reasonably use one of these methods.
   • The first method is the gross profits method. This method uses the historical gross profit margin.
   • The second method is the retail inventory method. It compares the retail price of goods sold to the cost in prior periods.
2. Use the gross profit method to estimate ending inventory. This result is driven by the historical gross profit margin. So it may not be completely accurate because this may not agree with the gross profit margin in the current accounting period. It can reasonably be used during interim periods between physical counts of inventory.
   • Add the value of the beginning inventory to the cost of purchases during the current accounting period. This tells you the value of the goods available during the period.
   • For example, suppose your beginning inventory was $200,000 and your total purchases were $250,000. Your total goods available would be <math>$200,000 + $250,000 = $450,000</math>.
   • Multiply your sales by (1 – expected gross profit margin) to estimate the cost of goods sold.
   • For example, suppose your gross profit margin for the past 12 months has been 30 percent. You could safely assume that it would be the same for the current period. If your sales were $800,000, estimate cost of goods sold with the equation <math>(1-.30) * $800,000 = $560,000</math>.
   • Subtract the estimated COGS from the estimated goods available to get the estimated ending inventory.
   • Using the above example, the estimated ending inventory would be $110,000. <math>$560,000 - $450,000 = $110,000</math>.
3. Use the retail inventory method to estimate ending inventory. This method does not use the historical gross profit margin. Instead, it compares the retail price to the cost of goods in prior periods. Note that this method is only valid if you always mark up your products by the same percentage. If you used a different mark-up rate or offered discounts during the current period, then this method would be inaccurate.
   • Calculate the ratio of cost to retail using the formula (cost / retail price).
   • For example, suppose you sold vacuum cleaners for $250 each, and the cost is $175. Calculate your cost-to-retail percentage with the equation <math>$175 / $250 = .70</math>. The cost-to-retail percentage is 70 percent.
   • Calculate the cost of goods available for sale with the formula (cost of beginning inventory + cost of purchases).
   • For example, your beginning inventory is $1,500,000 and your total purchases were $2,300,000. Your cost of goods available is <math>$1,500,000 + $2,300,000 = $3,800,000</math>.
   • Calculate the cost of sales during the period with the formula (sales * cost-to-retail percentage).
   • If you sales in this period were $3,400,000, then your cost of sales would be ($3,400,000 * .70 = $2,380,000</math>.
   • Calculate your ending inventory with the formula (cost of goods available for sale – cost of sales during the period).
   • Using the above example, your ending inventory would be <math>$3,800,000 - $2,380,000 = $1,420,000</math>.
4. Obtain an accurate ending inventory valuation periodically with a physical count or cycle count. For some situations, you must invest the time and resources to get an accurate physical count of your inventory. For example, your company may be preparing for an audit of your financial statements. Or you may be planning an acquisition or merger. In these cases, you need a precise calculation of inventory because an estimation won’t be accurate enough.
   • Conduct a complete count of inventory. This is known as a physical count. You do it at the end of a month, quarter or year. This method is labor intensive. Therefore, companies typically perform a physical count a limited number of times per year.
   • A cycle count is a method of counting inventory on an ongoing basis. A small amount of inventory is calculated each day. In a defined period, you cycle through the entire inventory. All items are counted on a rotating basis. This method is highly accurate and yields a high degree of confidence in the accuracy of the inventory valuation.

Calculating Cost of Goods Sold (COGS)

1. Calculate the cost of goods sold (COGS) if using a periodic inventory method. A periodic inventory method means that inventory is calculated at regular intervals. For example, you may count inventory monthly, quarterly or semi-annually. The formula is straightforward in this case: (Beginning Inventory + Purchases – Ending Inventory = COGS).
   • For example, suppose you have a business selling toasters. At the beginning of October, 2015, you had $900 of inventory on hand. During the month of October, 2015, you purchased $2,700 of inventory. Your inventory count at the end of the month showed that you had $600 of inventory left.
   • Calculate your COGS with the equation <math>$900 + $2,700 - $600 = $3,000</math>.
   • If you do physical inventory monthly, then you always know the beginning and ending inventory for the monthly accounting period.
   • If you do physical inventory less often, such as quarterly, then during the months in-between your physical counts, you will have to estimate the value of the ending inventory using the methods described above.
2. Calculate the COGS if using a perpetual inventory method. You use this type of method if you keep track of inventory on an item-by-item basis. For example, if you are a retail store that scans barcodes with point-of-sale scanners, then you are keeping track of inventory in real time.
   • If you are keeping track of changing inventory on an item-by-item basis, then when calculating the ending value of the inventory, you have to make some assumptions about which items in inventory were used first during the accounting period.
   • These assumptions are designed to help you account for changes in the cost of items in inventory.
   • The assumptions are known as the First-In-First-Out (FIFO), the Last-In-First-Out (LIFO) method and the Average cost method.
3. Calculate COGS using the FIFO method. Suppose you have a business selling dog collars online. You get all of your dog collars from one vendor. In the middle of November, 2015, your vendor increased the cost of one dog collar from $1.00 to $1.50. Using the FIFO method, you will assume that you sold the older $1.00 dog collars before the newer $1.50 collars.
   • Determine your beginning inventory. At the beginning of November, 2015, you had 50 dog collars on hand, all of which cost you $1.00 each. Your beginning inventory value was therefore $50 <math>(50 * $1.00 = $50.00)</math>.
   • Calculate your total purchases. During November, 2015, you purchased 100 dog collars: 60 at $1.00 each and 40 at $1.50 each. Your total purchases equal <math>(60 *$1.00) + (40 * $1.50) = $120</math>.
   • Calculate your total goods available for sale. This is your beginning inventory ($50) plus your purchases ($120), for a total of $170. Since you keep perpetual inventory, you know that of this $170 in inventory, 110 units were purchased for $1.00 each ($110), and 40 units were purchased for $1.50 each ($60).
   • You sell 100 dog collars in November, 2015. Using the FIFO method, assume you sold the oldest inventory first. You have 110 units of the $1.00 dog collars on hand. So you assume that all 100 dog collars you sold in November were the $1.00 units. Your COGS for November, 2015 is <math>100 * $1.00 = $100</math>.
   • You still have 10 units remaining of the $1.00 collars. You will need this information next month when you calculate COGS using FIFO.
4. Calculate COGS using LIFO. Using the same example, suppose you sell the newest collars first. Assume you sold 100 dog collars in November, 2015. Then, according to LIFO, you sold 40 units that cost you $1.50 each and 60 units that cost you $1.00 each.
   • Your COGS is <math>(40 * $1.50) + (60 * $1.00) = $120</math>.
5. Calculate COGS using the Average Cost method. With this method, you find the average of the beginning inventory costs and the purchase made during the month. First calculate the cost per unit. Then multiply this by the number of units on hand at the end of the accounting period. Use this calculation to determine both the COGS and the ending inventory balance.
   • Calculate the average cost per unit with the formula (Beginning Inventory + Purchases in dollars) / (Beginning Inventory + Purchases in units)
   • Using the example above, the cost per unit is $1.13: <math>($50 + $120) / (50 + 100) = $1.13</math>.
   • In the example above, you started with 50 units. During the month, you purchased 100 units for a total of 150 available units to sell. Then you sold 100 units, leaving you with 50 units on hand at the end of the month.
   • Calculate COGS by multiplying the average cost per unit with the total units sold.
   • <math>$1.13 * 100 = $113</math>
   • COGS = $113.
   • Calculate the ending inventory by multiplying the average cost per unit with the number of units left on hand at the end of the month.
   • <math>$1.13 * 50 = $56.50</math>
   • Ending inventory = $56.50.

Making Journal Entries

1. Record the journal entry if you are using a periodic inventory method. When using this method, the Inventory balance on your balance sheet remains the same until you do a physical count. In each accounting period during the interval between physical counts, an account called “Purchases” is used instead of debiting Inventory. When the physical count is completed, the balance in Inventory is adjusted.
   • Suppose you run a business selling T-shirts. You purchase the shirts for $6 and sell them for $12.
   • At the beginning of the period, you have 100 T-shirts on hand. The beginning value of your inventory is $600.
   • You purchase 900 T-shirts at $6 per piece, for a total of $5,400. Debit your Purchases account for $5,400, and credit Accounts Payable for $5,400.
   • You sell 600 T-shirts at $12 per piece, for a total of $7,200. Debit Accounts Receivable for $7,200 and credit Sales for $7,200.
   • Your ending inventory is 400 shirts at $6 per piece, for a total of $2,400. Debit Inventory for $1,800 and debit COGS for $3,600. Credit Purchases for $5,400.
2. Record the journal entry if you are using a perpetual inventory method. If you use this system, then you record COGS and adjust the balance in Inventory throughout the year. You will not need to do an adjustment for Inventory at the end of the year.
   • At the beginning of the period, you have 100 T-shirts on hand. The beginning value of your inventory is $600.
   • You purchase 900 T-shirts at $6 per piece, for a total of $5,400. Debit Inventory for $5,400. Credit Accounts Payable for $5,400.
   • You sell 600 T-shirts at $12 per piece, for a total of $7,200. Debit Accounts Receivable and credit Sales for $7,200. Debit COGS and credit Inventory for $3,600.
   • Your ending inventory is 400 shirts at $6 per piece, for a total of $2,400. You do not need to make any entry. You already recorded an entry in the Inventory account that brought the balance to $2,400.

Related Articles

• Calculate Double Declining Depreciation
• Calculate Average Operating Assets
• Incorporate in Pennsylvania
• Pay Commissions to Your Sales Staff

Sources and Citations

See also

• Calculate an Early Payment Discount
• Make a Balance Sheet for Accounting
• Become an Accountant
• Process Payroll
• Learn Business Accounting
• Create a Revocable Trust
• Pay Commissions to Your Sales Staff
• Account For Accumulated Depreciation
• Understand Debits and Credits
• Liquidate Assets

Read more ...

What links here

• Understand Debits and Credits
• Account for Stolen Inventory
• Calculate COGS