Finance_ COGS entry and method of recording

1. What is Cost of Goods Sold (COGS)?

COGS represents the direct costs incurred to produce or purchase the goods that were sold by a company during a specific accounting period. It includes costs like:

• For Retailers/Distributors: The purchase price of the inventory items, plus any freight-in (shipping costs to receive the goods), import duties, and other costs directly related to acquiring the goods.
• For Manufacturers: Direct materials, direct labor, and manufacturing overhead (factory rent, utilities, depreciation on factory equipment, etc.) allocated to the units sold.

COGS is a crucial expense shown on the Income Statement. Subtracting COGS from Revenue gives you Gross Profit. It only includes the costs of inventory actually sold, not inventory remaining on hand.

2. Calculation of COGS

The fundamental way to calculate COGS, especially under a periodic inventory system, is:

COGS = Beginning Inventory + Purchases (or Cost of Goods Manufactured) - Ending Inventory

Where:

• Beginning Inventory: The value of inventory you had at the start of the accounting period (this is the same as the ending inventory from the previous period).
• Purchases (or Cost of Goods Manufactured - COGM):
  • For retailers/distributors: The total cost of inventory purchased during the period (including freight-in, less purchase returns/discounts).
  • For manufacturers: The total cost of goods completed during the period (COGM), which incorporates direct materials used, direct labor, and manufacturing overhead.
• Ending Inventory: The value of inventory remaining unsold at the end of the accounting period. This is often determined by a physical inventory count or derived from a perpetual system.

Why this formula works: It assumes that goods available for sale (Beginning Inventory + Purchases) must either have been sold (COGS) or remain in inventory (Ending Inventory). So, Goods Available for Sale - Ending Inventory = Cost of Goods Sold.

3. Method of Recording (Inventory Systems)

How and when COGS is recorded depends heavily on the inventory system used:

• A. Periodic Inventory System:

  • Recording Method: Inventory levels and COGS are not tracked continuously. Instead, Purchases are recorded in a separate "Purchases" account during the period. A physical inventory count is performed at the end of the period to determine the Ending Inventory value. COGS is then calculated using the formula above only at the end of the period.
  • Journal Entries:
    • During the period (e.g., when buying inventory):

      Dr Purchases        $XXX
      Dr Freight-In       $YY
         Cr Accounts Payable / Cash   $ZZZ
      (To record purchase of inventory)
      

    • At the end of the period (to calculate and record COGS): This often involves closing entries. A common approach is a two-step process:
      1. Close Beginning Inventory and Purchases accounts into COGS:

         Dr Cost of Goods Sold          $AAA
            Cr Inventory (Beginning)      $BBB
            Cr Purchases                $CCC
            Cr Freight-In               $DDD
            (To transfer beginning inventory and net purchase costs to COGS)
         

         (Note: Purchase Returns & Allowances and Purchase Discounts would be debited here if they exist)
      2. Record Ending Inventory (from physical count) and adjust COGS:

         Dr Inventory (Ending)          $EEE
            Cr Cost of Goods Sold         $EEE
         (To record ending inventory and reduce COGS accordingly)
         

      The net effect in the COGS account after these entries will equal the calculated COGS value (Beg Inv + Purchases - End Inv).

• B. Perpetual Inventory System:

  • Recording Method: Inventory levels (both quantity and cost) are updated continuously every time inventory is bought or sold. COGS is calculated and recorded at the time of each sale. This system typically requires inventory management software, POS systems, or scanners.
  • Journal Entries:
    • When buying inventory:

      Dr Inventory          $XXX
         Cr Accounts Payable / Cash   $XXX
      (To record purchase of inventory directly into the Inventory asset account)
      

    • At the time of each sale (Two Entries):
      1. Record the revenue from the sale:

         Dr Accounts Receivable / Cash   $YYY (Selling Price)
            Cr Sales Revenue              $YYY
         (To record the sale)
         

      2. Record the cost of the inventory sold (COGS):

         Dr Cost of Goods Sold         $ZZZ (Cost of the specific item sold)
            Cr Inventory                $ZZZ
         (To record the cost of the sale and reduce inventory)
         

      The $ZZZ amount comes directly from the inventory records based on a cost flow assumption (FIFO, LIFO, Weighted Average, Specific ID).

4. Cost Flow Assumptions

When identical inventory items are purchased at different costs over time, you need a method to determine which cost to assign to COGS when an item is sold. Common methods include:

• FIFO (First-In, First-Out): Assumes the oldest inventory items are sold first.
• LIFO (Last-In, First-Out): Assumes the newest inventory items are sold first. ¹ (Note: LIFO is permitted under US GAAP but not IFRS).  
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• Weighted-Average Cost: Calculates an average cost for all available inventory items and uses this average cost to value COGS and ending inventory.
• Specific Identification: Tracks the actual cost of each specific item. Used for unique, high-value items (e.g., cars, jewelry).

The choice of cost flow assumption affects both the COGS value on the income statement and the Ending Inventory value on the balance sheet.

In summary, COGS calculation involves the Beg Inv + Purch - End Inv formula, but its recording and the timing of the calculation depend significantly on whether a periodic or perpetual inventory system is used. The perpetual system provides more timely information but requires more sophisticated tracking.