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What is "Cost of Goods Sold"?

Finance
Article
06/18/2015

Small-business owners should be familiar with the term costs of goods sold (COGS), as it ultimately impacts their profit and tax liability. Let’s take a look at what cost of goods sold is, how it’s calculated, and the importance of calculating it correctly in small business accounting.                                                   

What is Cost of Goods Sold?

COGS represents the direct costs involved in producing goods or buying products for resale. Direct costs for goods purchased for resale include the purchase price, freight, storage, packaging, and direct labor related to warehousing personnel. For manufactured goods, direct costs also include raw materials, labor, and production expenses. Other costs, such as transportation and advertising, are not included in COGS.

To calculate COGS, beginning inventory is added to current period purchases, and ending inventory is then deducted. Take this example of merchandise purchased for resale to see how COGS is calculated:

Beginning Inventory + Purchases - Purchase Returns and Allowances - Purchase Discount + Freight In - Ending Inventory = Cost of Goods Sold

COGS is treated differently than other business expenses such as office supplies, rent, utilities, wages, or insurance. While these expenses are recognized and deductible for tax purposes in the period they are paid or incurred, cost of goods sold is only deductible in the period that the goods are sold.

COGS in Inventory Accounting

COGS is an important factor in inventory accounting. The simple formula for determining the value of your goods at hand at the end of an accounting period is as follows:

Beginning inventory

+  Purchases

-   Cost of goods sold

------------------------------------

Ending inventory

Since costs associated with merchandise purchased for resale or materials purchased to create products do not become a part of COGS until the items are sold, valuing beginning and ending inventory accurately is very important. When there are errors in the inventory valuation, COGS will also be in error.

Financial Statement Presentation

On financial statements, COGS is shown as an expense subtracted from net sales; that figure equals the gross profit, which is then used to calculate net income. Cost of goods sold appears on a business's income statement as follows:

Net sales

-  Cost of goods sold

------------------------------------------

Gross profit

 

Gross profit

-  Operating expenses

------------------------------------------

Income from operations

 

Income from operations

-  Other income and expenses

------------------------------------------

Net income

As you can see, COGS is an important figure for small-business owners to calculate accurately, as it ultimately affects the accuracy of net income. And if net income is over or understated, income taxes will be assessed incorrectly and the profitability of the company will be in error. With so much at stake, it may be a good idea to consult an accounting or tax professional for help if you’re struggling to calculate COGS.

 

This website contains articles posted for informational and educational value. Paychex is not responsible for information contained within any of these materials. Any opinions expressed within materials are not necessarily the opinion of, or supported by, Paychex. The information in these materials should not be considered legal or accounting advice, and it should not substitute for legal, accounting, and other professional advice where the facts and circumstances warrant.