21 Sep What is Cost of Goods Sold?
If you sell a product for $20, do you have a $20 profit?
If you answered no, then you are correct.
If you answered yes, do not get discouraged.
This is a common misconception by many new business owners and mainly relies on one concept….
Cost of Goods Sold
If you’re a manufacturer, more complex accounting takes place.
In short, COGS is the difference between your selling price (revenue) and profit (the amount you gained from a sale).
If you buy a product for $10 and sell it for $15, your breakdown is:
Revenue: $15. This is the amount you sold it for.
Cost of Goods Sold: $10. This is the amount you paid for the product.
Profit: $5. This is the amount you gained from the sale.
Examples of Cost of Goods Sold
COGS in itself is not a diverse account.
It’s simply the amount paid for a product that is sold. The product itself will differ, but this can range from video games to tires.
As mentioned above, the main differences for COGS depends on how the product is acquired.
If you’re a retailer, your COGS is the price paid for the product. Price is the cost of a product plus shipping costs.
If you’re a manufacturer, then cost accounting takes place. Cost accounting is a complex subject that we won’t go into much detail on, but in short, cost accounting allocates expenses to a product.
If $100 of material and $100 of labor was needed to produce 100 units, then each unit would have a COGS of $2.
Cost of Goods Sold Role in Accounting
Type of Account
Cost of Goods Sold lowers profits, making it an expense account.
All expenses are income statement accounts, and COGS is no different.
One special mention for COGS: it is not an operating expense and should not be listed with these expenses. Instead, it needs to be listed after revenue, creating gross profit. More detail on this is mentioned in our next section.
As we just touched on, COGS is different from most expenses.
Unlike operating expenses, COGS is not part of daily operations. Instead, it is part of every sale.
Revenue is great, but financial readers want to see how much you’re making off this revenue.
Other categories like operating margins will provide a measurement, but it’s important to show gross margins too.
The calculation of gross margins is simple: Net Revenue – COGS = Gross Margins.
And proper income statement layout follows this calculation.
The following example provides a visual of how this would appear on an income statement.
Let’s stick with our assumption of a $15 sales price and a $10 COGS. We’ll also assume that this is the only transaction to take place in January.
January Income Statement
The above example shows our COGS. As mentioned, we bought the product for $10 and sold it for $15.
This creates a Gross Profit of $5, the amount we gained from this sale.
I know you’re not trying to be an accountant, but the basic concept of a journal entry is still very important for you to know.
Why is it important?
Because it gives you the underlying logic. Understanding the underlying logic allows you to understand any COGS situation, not just when you buy a product for $10 and sell it for $15.
With COGS, there’s really just one main journal entry – the journal entry that takes place when the sale takes place.
For the purposes of this journal entry, we’ll stick with our example (bought a product for $10 and sold it for $15).
COGS Journal Entry
The first area of impact is Cash.
When we sell our product, we receive cash for that sale (if it was sold on credit, cash would be replaced by Accounts Receivable). We sold the product at $15, and our cash account increased by this amount after the sale. Cash is an asset, and assets increase with debit transactions.
The second area of impact is our key area of focus, COGS. As we have mentioned, the cost of our product is $10. As we have also mentioned, COGS is an expense. Expenses increase with debit transactions, and our COGS figure increases by $10 after this journal entry.
On the other side of the equation, we start with inventory. We just sold $10 of inventory, and we must decrease our inventory account by this amount. Inventory is an asset, and assets decrease with credit transactions.
The last area of impact is our revenue account. We sold the product for $15, creating $15 in revenue. Revenue is an income account and income increases with credit transactions. Our revenue amount is $15 higher after this transaction.
Other Areas of Impact
COGS is an important account, but it has an indirect impact on many areas.
Directly, COGS only impacts one account: Gross Margins.
From a ratio standpoint, COGS is most popular in calculating inventory turnover days and Gross Margins.
The importance of COGS is to show investors and creditors how much money you’re making per sale. Some companies focus too much on revenues and forget about margins.
$1 Million of Revenues is great, but it means nothing if you have $0 of gross profit.
Moral of the story, choose your product or services wisely.
Low margin products are not worth your time; unless a residual income stream is created (i.e. selling iPhones at cost to make money off accessories).
Cost of Goods Sold Recap
- Expense account
- Calculated by cost of product (if purchased) or cost to create a product (if manufactured)
- The difference of this and revenue creates gross profit.
- Important measurement for businesses, provides base cost and how much you should sell it for.
- Listed below revenues and above gross profit.