This article is part of a larger series on Bookkeeping.
Cost of goods sold (COGS) is an accumulation of the direct costs that go into the goods sold by your company. This includes the cost of any materials used in production as well as the cost of labor needed to produce the goods. It doesn’t include indirect expenses such as distribution costs and marketing costs. Calculating and tracking your cost of goods sold is one of the most important tasks of a bookkeeper in order to make sure your business is profitable.
Cost of goods sold can be calculated by subtracting the ending inventory amount from the sum of the beginning inventory and inventory costs.
COGS = (Beginning Inventory + Inventory Costs) – Ending Inventory
Step 1: Determining Inventory Costs
Inventory costs aren’t only the prices paid to purchase items, but also the cost of storing and maintaining those items for however long it takes it to sell them. The costs that go into calculating the cost of inventory are the cost of purchases, cost of materials, cost of direct labor, and other costs.
Cost of Purchases
This is the total amount spent for the products you placed in your inventory for selling purposes.
Cost of Materials
This is the cost of materials and supplies needed to manufacture your product. They have to be directly related to the production of your goods.
Cost of Direct Labor
This is the cost of paying employees who work on creating your products. This doesn’t include costs for employees in finance, marketing, sales, or any other administrative areas.
These include the shipping costs necessary to receive your materials and supplies, as well as overhead costs like rent, water, and electricity for the building or area where the products are assembled or manufactured. Overhead costs for administrative offices, retail space, or showrooms aren’t inventory costs.
The sum of all these costs incurred during the year makes up the inventory costs in the above formula.
Step 2: Determining the Cost of Ending Inventory
This is the total cost of all the items in your inventory at the end of the year. It’s a good idea to take a physical inventory count at least once a year, if not more. Don’t assume that what your accounting software reports matches exactly what you have in the warehouse. Theft and damage to products are the primary reasons for differences between the inventory on the books and what’s actually in the warehouse.
Take a Physical Inventory
A physical inventory is a method of manually counting your inventory and comparing it against recorded numbers. This count is usually performed at the end of the reporting period. Taking a physical inventory helps you to determine the accurate quantity on hand. Be sure to remove from physical inventory any items that are obsolete and unlikely to be sold. An inventory aging report is a great tool for helping to identify items that have been in inventory for an extended period of time.
Determine Cost to Assign to the Quantity on Hand
Your inventory includes your stock of products, parts, and materials. Once you know the physical quantities of your various inventory items, you need to determine a method to assign them inventory costs.
Assume Paul’s Plumbing purchases 1,000 widgets during the year. They purchased 500 widgets at $10 per unit on March 3 and another 500 widgets at $13 each on September 9.
At the end of the year, they have 25 widgets in inventory. How much did they pay for those 25 remaining widgets—$10, $13, or something else? The answer is complicated and depends upon Paul’s Plumbing’s inventory valuation method.
There are four main inventory valuation methods, which include specific identification; average cost; first-in, first-out (FIFO); and last-in, first-out (LIFO).
Here’s an explanation of each method.
The specific identification method is used to track individual items of inventory. This method is applicable when individual items can be identified clearly, such as with a serial number on boats, cars, or large pieces of equipment. This method creates a high degree of accuracy in the cost of inventory since the exact cost of items in ending inventory can be recorded. However, specific identification isn’t practical when a large number of indistinguishable items are purchased, like the widgets in our example above.
The average cost method tracks the average cost of identical units purchased during the year. Each item in the ending inventory is assigned the average cost of those items purchased during the year. Average cost is often the easiest to apply and least expensive to maintain out of the different inventory valuation methods. It works well when it’s difficult to track the cost associated with specific units or when there are large volumes of similar items moving through inventory.
# of Units
Cost Per Unit
To find the average cost per unit, take the total cost for all of the units, $11,500, and divide it by the total number of units, 1,000. This results in an average cost per unit of $11.50. Therefore, the remaining 25 units of inventory are valued at $11.20 each, for a total of $287.50.
The FIFO method of inventory valuation is based on the assumption that the sale or usage of goods follows the same order in which they’re purchased. Under this method, the earliest purchased or produced goods are sold first. Therefore, the products in inventory at the end of the year are the ones that were purchased most recently.
To determine the ending inventory using the FIFO method, use the cost per unit for the products in inventory that were purchased most recently. Since the cost per unit for the most recent purchase was $13, you would multiply $13 by 25 remaining units for a total of $325.
The LIFO inventory method assumes that the last items placed in inventory are the first sold. Therefore, the units in ending inventory are assumed to be the earliest units purchased or produced. LIFO is the most difficult inventory valuation method to apply because if you continue to purchase new inventory, older inventory costs might remain in ending inventory for years or even decades.
To determine the ending inventory using the LIFO method, use the cost per unit for the earliest purchased products in inventory. Since the cost per unit for the earliest purchased products was $10, you would multiply $10 by 25 remaining units for a total of $250.
Because the value of ending inventory under each inventory valuation method is different, the cost of goods sold will be different as well. Here’s a summary of our examples:
Inventory Valuation Method
If prices are continually increasing, as in the case of Paul’s Plumbing, LIFO will always result in lower gross income than average cost and FIFO. This makes LIFO very attractive for tax purposes. However, if you use LIFO for taxes, you’re required to also use it for your financial statements.
Step 3: Adjust Ending Inventory
The final step is to adjust the ending inventory shown on your balance sheet to the amount calculated in Step 2. The adjusting journal entry will differ based on whether you use a perpetual vs periodic inventory system. While each method requires an adjustment to the inventory account on the balance sheet, the offsetting entry should go to cost of goods sold if you use a perpetual inventory system or purchases if you use a periodic inventory system.
Perpetual Inventory System
A perpetual inventory system automatically updates and records the inventory account every time a sale or purchase of inventory occurs. This can be considered “recording as you go,” where the recognition of each sale or purchase occurs immediately. You need good small business accounting software with inventory accounting if you want to use a perpetual inventory system.
With a perpetual inventory system, your ending inventory and cost of goods sold should theoretically be correct without any adjustment. However, in reality, inventory shrinkage occurs, and you’ll need to adjust the ending inventory from your perpetual system to the amount you calculated in step 2.
With a perpetual inventory system, you’ll generally be decreasing the ending inventory shown in the perpetual system to the amount per your physical count. Occasionally, the entry could go in the other direction, but inventory generally has unexplained shrinkage, not expansion. The entry to adjust inventory to its correct amount is offset by an entry to cost of goods sold:
In the above entry, inventory is adjusted downward by $1,250 for shrinkage, and the COGS is increased for the shrinkage.
Periodic Inventory System
A periodic inventory system doesn’t adjust the inventory account during the year. All inventory purchases and other costs are recorded directly to a cost of goods sold account called either “inventory costs” or “purchases,” depending on your type of business. Recall the equation from the top of our article, slightly rearranged:
COGS = Inventory Costs + (Beginning Inventory – Ending Inventory)
Our adjusting entry at the end of the year is to adjust inventory costs for the change in inventory. After the adjustment, inventory costs equal COGS.
The entry above adjusts inventory for a $250 increase during the year and reduces inventory costs by $250. The inventory costs account now equals COGS.
Calculating cost of goods sold is necessary for any small business. Not only do you need to know this for tax purposes, but it can also help you better understand how your business is doing so you know which areas are doing well and which you need to improve upon. By following the steps above, you’ll be able to determine the best method for you.