Inventory and Cost of Goods Sold
Introduction to Inventory and Cost of Goods Sold
Cost 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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