The income statement details a company’s financial performance. This statement includes revenues and expenditures. Based on those items, it calculates several types of profits. However, it must categorize expenses into several categories depending on their nature. One of these classifications includes the cost of goods sold.
What is the Cost of Goods Sold?
The cost of goods sold (COGS) is an item that appears on the income statement. It includes all expenses related to manufacturing or purchasing goods. In essence, it consists of all the direct costs incurred in the process. COGS includes material and labour costs and other factory overheads. This cost also directly relates to the revenues generated during a period.
The cost of goods sold allows companies to calculate the gross profit. These profits include earnings from selling products only. Since it ignores indirect costs, the cost of goods sold indicates the expenses related to production or purchase. In some cases, companies may also refer to the cost of goods sold as the cost of sales. It is also directly proportional to the activity level during a specific period.
How does the Cost of Goods Sold work?
Companies combine expenses under one heading in the income statement based on their nature. These items help calculate different types of profits. The cost of goods sold accumulates direct expenses relating to the production process. In some cases, companies may sell manufactured goods purchased from other companies. The cost of goods sold covers the purchase expenses in those situations.
Usually, the cost of goods sold includes variable costs related to activity levels. For example, they will cover direct material and direct labour expenses. Apart from these, the cost of goods sold may also consist of fixed costs. For instance, factory overheads, holding costs, etc., fall into this category. However, it excludes selling and administrative expenses.
What is the accounting for the Cost of Goods Sold?
The accounting for the cost of goods sold is straightforward. Companies record expenses into their general ledgers. Usually, each account within the financial system has a type. Consequently, each expense account will become a part of a different heading in the income statement. Companies categorize direct expenses as the cost of goods sold.
Therefore, any amounts in those accounts will constitute the cost of goods sold in the income statement. The accounting process for those expenses will remain the same. Based on the classification, companies will present them under different headings. Through this process, companies separate expenses relating to the cost of goods.
Is the Cost of Goods Sold an income statement item or a balance sheet item?
As mentioned above, the cost of goods sold primarily relates to the income statement. Usually, it is the second line item on that statement. Since it includes expenses, it is crucial in calculating profits. Therefore, it becomes a part of the income statement. In contrast, the cost of goods sold does not appear on the balance sheet directly.
However, the cost of goods sold relates to the balance sheet indirectly. It requires opening and closing inventories, which come from the balance sheet. These items can increase or decrease the cost of sales reported in the income statement. Similarly, the cost of goods sold also impacts retained earnings in the balance sheet.
Conclusion
The cost of goods sold includes all direct costs related to producing or purchasing products. It appears on the income statement as an expense. Usually, companies account for the cost of sales by categorizing expenses into the cost of goods sold category. It is primarily a part of the income statement. However, the cost of goods sold can also indirectly impact the balance sheet.
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