In business accounting there are several statements that help a business owner determine the health of their company. Interpreting the financial statements can be confusing and double-checking for accuracy can be frustrating. The cost of goods and services is the overall amount of money a business spends to provide their goods or services. The operating income covers overhead expenses like rent, utilities, taxes and payroll.
Knowing how much is spent on goods and services is vital to analyzing your gross profit, your profit margin and net income. Knowing how much you made on your goods and services is even more important. Learn how to interpret financial statements in this online course.
Cost of Goods and Services (COGS)
Cost of goods and services encompasses any materials purchased to manufacture or acquire the items that generate income. If you run a pizza shop, some of your COGS would include dough, sauce, meats, vegetables, boxes, ovens, utensils and so on. Without these items – there would be no pizza – and without pizza, there is no money. Now COGS can be broken down into fixed and current assets. Fixed assets are income generating items that depreciate over time and are not sold directly to the customer. These kind of assets include the pizza oven and dough trays. Current assets include the items that will be turned into cash within 12-months and are sold directly to the customers. The edible products would be considered current assets. In the course Basics of Accounting you can learn more about assets, operating income, cash flow and other vital financial measures. Why does the cost matter when calculating the cost of goods sold? During the period method of inventory it’s essential to see the inflow and outflow of money in respect to the goods being produced and sold.
Cost of Goods Sold Formula
Periodic inventory requires business managers to periodically take stock (count) inventory. There are several methods in which inventory can be managed but a company should always, at least once a year, count their inventory. This helps account for lost goods, stolen goods, and damaged goods that may not be recorded in your financial reports (because no one knew about them). The cost of goods sold formula is a measurement tool to understand how much inventory was purchased initially, purchased throughout and furthermore, sold during a designated period of time.
The formula for cost of goods sold is:
Beginning inventory + inventory purchases – end inventory = cost of goods sold
So let’s break this down to gain a better understanding of the variables of this equation.
- Beginning Inventory
This is the amount of inventory you begin the accounting period with. Let’s assume that you measure the cost of goods sold every quarter. At the beginning of the quarter you accounted for $3,000 worth of inventory for sale. This is the beginning inventory amount.
- Inventory Purchases
Somewhere in the middle of the quarter you noticed you were getting a little low on a few items. In order to keep a well-stocked store, you placed an order for more of those items. This total purchase costs you $2,000.
- End Inventory
At the end of the quarter (since this is when you do your periodic inventory count) you see that you only have $1,000 worth of inventory left in the store. This is the end inventory amount.
Let’s plug these figures into the equation and see what we get.
$3,000 + $2,000 – $1000 = $4,000
The outcome of this equation says the cost of goods sold was $4,000 for this quarter. It’s important to note that the cost of goods sold formula will not account for stolen items. Stolen items will obviously not be in the inventory when it’s counted, but it’s also impossible to know if the missing items were paid for or not until digging into the COGS report. Interested in financial formulas? Learn more important ones like profit margin and net income in an Introduction to Financial Accounting course.
The cost of goods sold formula is a nice and easy way to get a vague picture of the money output for your inventory. However, it’s incredibly important to review your COGS report to analyze manufacture cost changes, discounts, damages and so on. These factors will give you a more accurate description of your current assets, revenue and profit margin.
In the article the importance of accounting you can uncover so many more reasons why knowing basic accounting is beneficial to you and your venture. Understanding your business through a numbers lens is going to give you the upper hand in making important decisions about your company’s future. Learn more in the course your business by the numbers.