What Is Cost of Goods Sold?

By Markets Fool.com

The goal of all businesses is to make money, so the cheaper it is for a business to produce a product or offer a service, the more that company stands to profit. Cost of goods sold, or COGS, is a term used to describe the cost of producing or creating a product or service. It covers costs such as materials, inventory, production equipment, labor, and overhead, which are directly related to the products or services themselves.

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Reporting and calculating cost of goods sold

Cost of goods sold appears on a company's income statement. When subtracted from a company's revenue, it is a clear measure of a company's gross profit, which is the amount a company makes on the sale of a product or service before deducting sales and administrative expenses.

Though the exact costs included in a cost of goods sold calculation might vary from one business to another, the most basic way to arrive at this figure is to start with beginning inventory for a given period, add all inventory purchases made during that period, and then subtract the ending inventory.

Let's say a company starts out with $200,000 in inventory, purchases another $100,000 in inventory during the period in question, and ends the period with $50,000 in inventory. In this case, the cost of goods sold would be $250,000 ($200,000 + $100,000 $50,000 = $250,000).

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Significance of cost of goods sold

So what's in a number? A company's cost of goods sold shows us how well it's doing at turning inventory into profit, but for the cost of goods sold to really mean anything, we need to compare it to revenue for the period in question. In our example, if the company's revenue for the period exceeded $250,000, then its gross profit would be positive. On the other hand, if the company's revenue fell below $250,000, then its gross profit would be negative, and that's a bad thing.

Periodic versus perpetual inventory systems

Periodic and perpetual systems are two different accounting methods that businesses use to keep track of their inventory. In a periodic inventory system, cost of goods sold is calculated by taking the beginning inventory, adding inventory purchases, and subtracting ending inventory. The inventory itself is counted occasionally and then updated at the end of the period in question. In a perpetual inventory system, inventory is counted continuously as it is sold and received. Purchases and returns are recorded immediately, and the cost of goods sold is updated as each sale is made.

The periodic inventory system is usually more appropriate for small businesses or business that see lower sales volume. An auto dealership, for example, usually doesn't move nearly as much inventory as a clothing retailer, and as such, the periodic system, which typically involves tracking inventory manually, can be easily employed. The perpetual inventory system, on the other hand, is usually favored by larger businesses with high sales volume and multiple retail locations. Supermarkets, for example, need perpetual inventory systems and typically employ digital technology to ensure that inventory, sales, and returns are recorded accurately.

No matter which accounting system a business uses, it should always strive to keep its cost of goods sold as low as possible. If a company's cost of goods sold keeps rising year to year, it can compromise its ability to remain profitable.

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