Inventory and Cost of Goods Sold

Cost of Goods Sold
Cost Flow Assumptions
Write-downs and allowances
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Introduction to Inventory and Cost of Goods Sold

Inventory and Cost of Goods SoldCost of goods sold (COGS) refer to the inventory costs of those goods a business has sold during a particular period. Costs are associated with particular goods using one of several formulas, including specific identification, first-in first-out (FIFO), or average cost. Costs include all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition. Costs of goods made by the business include material, labor, and allocated overhead. The costs of those goods not yet sold are deferred as costs of inventory until the inventory is sold or written down in value.

Inventory is reported as a current asset on the company's balance sheet. Inventory is a significant asset that needs to be monitored closely. Too much inventory can result in cash flow problems, additional expenses (e.g., storage, insurance), and losses if the items become obsolete. Too little inventory can result in lost sales and lost customers.

Many businesses sell goods that they have bought or produced. When the goods are bought or produced, the costs associated with such goods are capitalized as part of inventory (or stock) of goods.These costs are treated as an expense in the period the business recognizes income from sale of the goods.

Determining costs requires keeping records of goods or materials purchased and any discounts on such purchase. In addition, if the goods are modified,the business must determine the costs incurred in modifying the goods. Such modification costs include labor, supplies or additional material, supervision, quality control, use of equipment, and other overhead costs. Principles for determining costs may be easily stated, but application in practice is often difficult due to a variety of considerations in the allocation of costs.

Cost of goods sold may also reflect adjustments. Among the potential adjustments are decline in value of the goods (i.e., lower market value than cost), obsolescence, damage, etc.

When multiple goods are bought or made, it may be necessary to identify which costs relate to which particular goods sold. This may be done using an identification convention, such as specific identification of the goods, first-in-first-out (FIFO), or average cost. Alternative systems may be used in some countries, such as last-in-first-out (LIFO), gross profit method, retail method, or combinations of these.

Inventories have a significant effect on profits. A business that makes or buys goods to sell must keep track of inventories of goods under all accounting and income tax rules.

Cost of goods sold may be the same or different for accounting and tax purposes, depending on the rules of the particular jurisdiction.

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Cost of Goods Sold

Cost of goods sold is the cost of the merchandise that was sold to customers. The cost of goods sold is reported on the income statement when the sales revenues of the goods sold are reported.

Cost of goods purchased for resale includes purchase price as well as all other costs of acquisitions.This cost should reflect any discounts. Additional costs may include freight paid to acquire the goods, customs duties, sales or use taxes not recoverable paid on materials used, and fees paid for acquisition.

The cost of goods produced in the business should include all costs of production.The key components of cost generally include:

  • Parts, raw materials and supplies used,
  • Labor, including associated costs such as payroll taxes and benefits, and
  • Overhead of the business allocable to production.

Most businesses make more than one of a particular item. Thus, costs are incurred for multiple items rather than a particular item sold. Determining how much of each of these components to allocate to particular goods requires either tracking the particular costs or making some allocations of costs. Parts and raw materials are often tracked to particular sets (e.g., batches or production runs) of goods, then allocated to each item.

Labor costs include direct labor and indirect labor. Direct labor costs are the wages paid to those employees who spend all their time working directly on the product being manufactured. Indirect labor costs are the wages paid to other factory employees involved in production. Costs of payroll taxes and fringe benefits are generally included in labor costs, but may be treated as overhead costs. Labor costs may be allocated to an item or set of items based on timekeeping records.

Materials and labor may be allocated based on past experience, or standard costs. Where materials or labor costs for a period exceed the expected amount of standard costs, a variance. Such variances are then allocated among cost of goods sold and remaining inventory at the end of the period.

Determining overhead costs often involves making assumptions about what costs should be associated with production activities and what costs should be associated with other activities. Traditional cost accounting methods attempt to make these assumptions based on past experience and management judgment as to factual relationships. Activity based costing attempts to allocate costs based on those factors that drive the business to incur the costs.

Overhead costs are often allocated to sets of produced goods based on the ratio of labor hours or costs or the ratio of materials used for producing the set of goods.

Variable production overheads are allocated to units produced based on actual use of production facilities. Fixed production overheads are often allocated based on normal capacities or expected production.More or fewer goods may be produced than expected when developing cost assumptions (like burden rates). These differences in production levels often result in too much or too little cost being assigned to the goods produced. This also gives rise to variances.

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Cost Flow Assumptions

In some cases, the cost of goods sold may be identified with the item sold. Ordinarily, however, the identity of goods is lost between the time of purchase or manufacture and the time of sale.Determining which goods have been sold, and the cost of those goods, requires either identifying the goods or using a convention to assume which goods were sold. This may be referred to as a cost flow assumption or inventory identification assumption or convention.The following methods are available in many jurisdictions for associating costs with goods sold and goods still on hand:

  • Specific identification. Under this method, particular items are identified, and costs are tracked with respect to each item.This may require considerable recordkeeping. This method cannot be used where the goods or items are indistinguishable or fungible.
  • Average cost. The average cost method relies on average unit cost to calculate cost of units sold and ending inventory. Several variations on the calculation may be used, including weighted average and moving average.
  • First-In First-Out (FIFO) assumes that the items purchased or produced first are sold first. Costs of inventory per unit or item are determined at the time made or acquired. The oldest cost (i.e., the first in) is then matched against revenue and assigned to cost of goods sold.
  • Last-In First-Out (LIFO) is the reverse of FIFO. Some systems permit determining the costs of goods at the time acquired or made, but assigning costs to goods sold under the assumption that the goods made or acquired last are sold first. Costs of specific goods acquired or made are added to a pool of costs for the type of goods. Under this system, the business may maintain costs under FIFO but track an offset in the form of a LIFO reserve. Such reserve (an asset or contra-asset) represents the difference in cost of inventory under the FIFO and LIFO assumptions. Such amount may be different for financial reporting and tax purposes under different jurisdictions.
  • Dollar Value LIFO. Under this variation of LIFO, increases or decreases in the LIFO reserve are determined based on dollar values rather than quantities.
  • Retail inventory method. Resellers of goods may use this method to simplify recordkeeping. The calculated cost of goods on hand at the end of a period is the ratio of cost of goods acquired to the retail value of the goods times the retail value of goods on hand. Cost of goods acquired includes beginning inventory as previously valued plus purchases. Cost of goods sold is then beginning inventory plus purchases less the calculated cost of goods on hand at the end of the period.

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Write-downs and allowances

The value of goods held for sale by a business may decline due to a number of factors. The goods may prove to be defective or below normal quality standards (subnormal). The goods may become obsolete. The market value of the goods may simply decline due to economic factors.

Where the market value of goods has declined for whatever reasons, the business may choose to value its inventory at the lower of cost or market value, also known as net realizable value.This may be recorded by accruing an expense (i.e., creating an inventory reserve) for declines due to obsolescence, etc. Current period net income as well as net inventory value at the end of the period is reduced for the decline in value.

Any property held by a business may decline in value or be damaged by unusual events, such as a fire. The loss of value where the goods are destroyed is accounted for as a loss, and the inventory is fully written off. Generally, such loss is recognized for both financial reporting and tax purposes. However, book and tax amounts may differ under some systems.

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