Cost of goods sold (COGS) refers to the inventory costs of those goods a business has sold during a particular period. Costs are associated with particular goods using one of several formulas, including specific identification, first-in first-out (FIFO), or average cost. Costs include all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition. Costs of goods made by the business include material, labor, and allocated overhead. The costs of those goods not yet sold are deferred as costs of inventory until the inventory is sold or written down in value.
Overview
Many businesses sell goods that they have bought or produced. When the goods are bought or produced, the costs associated with such goods are capitalized as part of inventory (or stock) of goods. These costs are treated as an expense in the period the business recognizes income from sale of the goods.
Determining costs requires keeping records of goods or materials purchased and any discounts on such purchase. In addition, if the goods are modified,the business must determine the costs incurred in modifying the goods. Such modification costs include labor, supplies or additional material, supervision, quality control, use of equipment, and other overhead costs. Principles for determining costs may be easily stated, but application in practice is often difficult due to a variety of consideration in the allocation of costs.
Cost of goods sold may also reflect adjustments. Among the potential adjustments are decline in value of the goods (i.e., lower market value than cost), obsolescence, damage, etc.
When multiple goods are bought or made, it may be necessary to identify which costs relate to which particular goods sold. This may be done using an identification convention, such as specific identification of the goods, first-in-first-out (FIFO), or average cost. Alternative systems may be used in some countries, such as last-in-first-out (LIFO), gross profit method, retail method, or combinations of these.
Cost of goods sold may be the same or different for accounting and tax purposes, depending on the rules of the particular jurisdiction.
Importance of inventories
Inventories have a significant effect on profits. A business that makes or buys goods to sell must keep track of inventories of goods under all accounting and income tax rules. An example illustrates why. Fred buys auto parts and resells them. In 2008, Fred buys $100 worth of parts. He sells parts for $80 that he bought for $30, and has $70 worth of parts left. In 2009, he sells the remainder of the parts for $180. If he keeps track of inventory, his profit in 2008 is $50, and his profit in 2009 is $110, or $160 in total. If he deducted all the costs in 2008, he would have a loss of $20 in 2008 and a profit of $180 in 2009. The total is the same, but the timing is much different. All countries’ accounting and income tax rules (if the country has an income tax) require the use of inventories for all businesses that regularly sell goods they have made or bought.
Cost of goods for resale
Cost of goods purchased for resale includes purchase price as well as all other costs of acquisitions. This cost should reflect any discounts. Additional costs may include freight paid to acquire the goods, customs duties, sales or use taxes not recoverable paid on materials used, and fees paid for acquisition. For financial reporting purposes such period costs as purchasing department, warehouse, and other operating expenses are usually not treated as part of inventory or cost of goods sold. For U.S. income tax purposes, some of these period costs must be capitalized as part of inventory. Costs of selling, packing, and shipping goods to customers are treated as operating expenses related to the sale. Both International and U.S. accounting standards require that certain abnormal costs, such as those associated with idle capacity, must be treated as expenses rather than part of inventory.
Value added tax is generally not treated as part of cost of goods sold if it may be used as an input credit or otherwise recoverable from the taxing authority
Cost of goods made by the business
The cost of goods produced in the business should include all costs of production. The key components of cost generally include:
- Parts, raw materials and supplies used,
- Labor, including associated costs such as payroll taxes and benefits, and
- Overhead of the business allocable to production.
Most businesses make more than one of a particular item. Thus, costs are incurred for multiple items rather than a particular item sold. Determining how much of each of these components to allocate to particular goods requires either tracking the particular costs or making some allocations of costs. Parts and raw materials are often tracked to particular sets (e.g., batches or production runs) of goods, then allocated to each item.
Labor costs include direct labor and indirect labor. Direct labor costs are the wages paid to those employees who spend all their time working directly on the product being manufactured. Indirect labor costs are the wages paid to other factory employees involved in production. Costs of payroll taxes and fringe benefits are generally included in labor costs, but may be treated as overhead costs. Labor costs may be allocated to an item or set of items based on timekeeping records.
Materials and labor may be allocated based on past experience, or standard costs. Where materials or labor costs for a period exceed the expected amount of standard costs, a variance. Such variances are then allocated among cost of goods sold and remaining inventory at the end of the period.
Determining overhead costs often involves making assumptions about what costs should be associated with production activities and what costs should be associated with other activities. Traditionalcost accounting methods attempt to make these assumptions based on past experience and management judgment as to factual relationships. Activity based costing attempts to allocate costs based on those factors that drive the business to incur the costs.
Overhead costs are often allocated to sets of produced goods based on the ratio of labor hours or costs or the ratio of materials used for producing the set of goods. Overhead costs may be referred to as factory overhead or factory burden for those costs incurred at the plant level or overall burden for those costs incurred at the organization level. Where labor hours are used, a burden rate or overhead cost per hour of labor may be added along with labor costs. Other methods may be used to associate overhead costs with particular goods produced. Overhead rates may be standard rates, in which case there may be variances, or may be adjusted for each set of goods produced.
Variable production overheads are allocated to units produced based on actual use of production facilities. Fixed production overheads are often allocated based on normal capacities or expected production. More or fewer goods may be produced than expected when developing cost assumptions (like burden rates). These differences in production levels often result in too much or too little cost being assigned to the goods produced. This also gives rise to variances.