The Cost of Goods Sold is an important accounting term. It is more-or-less what it sounds like, being the sum of the costs that were incurred for the purpose of producing the goods that were sold in a particular time period. As a result, it isn’t a single expense but rather a number of related expenses collected under the same name, with some common examples including the cost of purchases, the cost of materials, and the cost of labor. Sometimes, the Cost of Goods Sold is called either the Cost of Sales or the Cost of Goods Manufactured or something similar, which mean much the same thing but are meant for businesses that are reliant on other business models.
Why Is the Cost of Goods Sold So Important?
First and foremost, the Cost of Goods Sold is important because of the Matching Principle. In short, the Matching Principle is one of the accounting rules that are meant to form a common basis for financial statements so that interested individuals will have an easier time interpreting the information presented to them through said documents. Like its name suggests, it states that expenses should be matched to the same time periods as the revenues that they helped to produce.
For example, if a business pays the costs for six months of subscription to a service, the Matching Principle says that it shouldn’t record the full sum as a single expense at the time of payment. Instead, the likeliest recommendation is that it records the full sum as an asset so that its value can be deducted six times in six months to reflect the fact that the subscription was used over those six time periods. Likewise, when a business makes revenue by selling either a product or a service, it needs to record the costs that were used to make that possible, thus resulting in the Cost of Goods Sold as well as all of its similar but not quite the same counterparts.
As for why this is so important, well, suffice to say that accounting is supposed to create faithful representations of financial truths. In this context, even though it makes accounting more complicated and time-consuming, the matching of revenues and expenses produces a more accurate picture of how a business is using its resources to run its revenue-earning operations, thus making it more useful to interested individuals as well.
How Can the Cost of Goods Sold Be Calculated?
With that said, the exact method used to calculate the Cost of Goods Sold can see a fair amount of variation because there are a lot of businesses out there that use a lot of business models. Due to this, said calculations can be simple in some cases but much more challenging in others.
For example, suppose a business purchases products before selling them to their customers. Each purchase would result in the increase of inventory, which is a catch-all for the products that a business has on hand. Whenever the business makes a sale, there will be a deduction to the inventory as well as an increase in the Cost of Goods Sold for that particular time period. In cases when the products are easily distinguishable from one another, the business will just use the cost at which it purchased the product that was sold. However, when products are not so easily distinguishable from one another, a business can use a number of methods for determining the amount that is deducted as Cost of Goods Sold. FIFO and LIFO are two of the most common options, standing for First In, First Out and Last In, First Out respectively. However, there are other methods as well, with an excellent example being WAC, which stands for Weighted Average Cost.
Other business models can add further complications. For example, suppose a business purchases some of its products and makes the rest of its products. It will have to perform the accounting for the purchases as well as their sales to their customers. Furthermore, it will have to perform the accounting for the manufactured products as well as their sales to their customers. Generally speaking, interested individuals can figure out whether something should be included in the Cost of Goods Sold or not by checking whether they are directly relevant or not. For example, the cost of labor for the person who made the product would be counted as Cost of Goods Sold. In contrast, the cost of labor for the person who sold the product would not be counted as such. After all, the Cost of Goods Sold means the costs incurred to secure the goods that were sold, meaning that neither selling nor indirect overhead should be counted as part of it.