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Inventory

Companies that are involved in the manufacturing and selling of physical goods are required to record them as assets in their books and expenses at the time of their sale. Manufacturing companies usually deal with three different kinds of inventories which are materials, work in process and finished goods. Retailers only have to deal with one inventory which is merchandise. In all cases, a company has to sell inventories in order to make profits. Before it is sold, it serves as an asset for the company, however, after merchandise is sold, the cost coverts into an expense, called Cost of Goods Sold (COGS). The cost is then transferred from a balance sheet to an income statement via journal entry in bookkeeping terms.

Companies maintain a significant amount of inventory to manage their day to day operations. However, it is an important asset which needs to be monitored closely. Storing too much inventory can cause issues related to decreasing cash flows, storage costs and losses in case the item turns archaic. Similarly, too little of it can result in lost sales and customers.

Indirect costs or overhead costs that cover depreciation, factory maintenance, cost of factory management, electricity, etc. are allocated to inventory, depending on the production levels. Overheads are frequently assigned based on direct labor hours or a number of machine hours.

Cost of Goods Sold

Cost of Goods Sold basically represents the cost of goods or merchandise that has been sold to customers. Unlike inventory, which is mentioned on the balance sheet, cost of goods is reported on the income statement. All of the costs that are occurred in order to get the merchandise into the inventory and then ready for sale are included in the cost of goods. The cost of acquiring it from the supplier, shipping costs, and all other costs are included. Direct materials, labor, and overhead costs are also included in the cost of goods sold.

For services, the cost of goods would account for labor, payrolls, and benefits. Basically, all of the direct costs that are associated with the production of the product is the cost of goods. It is important to highlight that goods that are not sold during the year and are still in inventory would not be included to calculate the COGS. Only the goods that were sold are included.

Cost Flow Assumptions

There are basically three methods that are accepted by the IRS to move the cost from the balance sheet to the income statement. FIFO (First In First Out), LIFO (Last In First Out) and Average Cost are the accepted methods. They are exactly what the names suggest. First in first out means that goods that arrive first should be removed first at an original cost. It doesn’t matter if the cost of goods sold has increased for the new batch, you would have to record at an original price. 

Each cash flow assumption can be used in both of the systems mentioned below.

Periodic Inventory System

Under the periodic system, the amount in the inventories account is not updated at the time of purchase. In fact, the account is only updated at the end of a year. This means that for the whole year the account would show the cost of last year’s stock.

All the purchases related to merchandise are recorded in either one or more purchase accounts. At the time of year-end, the purchase accounts are closed and the stock account is matched with the cost of merchandise at hand. Under the periodic system, cost of goods sold does not exist in the account to record the sale of merchandise. It is simply calculated as beginning stock + new purchases – ending stock. You would not be able to calculate it while looking at a general ledger account.

Perpetual Inventory System

Under a perpetual system, the stock account is continuously updated. The cost of merchandise that is purchased from the suppliers is added to the account, while what is sold to the customers is continuously being reduced from the account. There is no room for purchase accounts under this system.

The cost of goods sold account is debited at the time of the sale, exactly for the cost associated with the merchandise. For the sale of any merchandise, there have to be two recorded journal entries. Sales and accounts receivable are recorded as one entry while the other caters to the reduction of inventory and increase in the cost of goods that are sold.

FIFO, LIFO and Average cash flow assumptions are combined with either perpetual or periodic systems to account for the cost of stock at hand. It is up to you to choose any one of them at your convenience. 

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The cumulative cost of selling a particular product is called Cost of Goods Sold (COGS). It varies from product to product and increases with factors such as complexity of the manufacturing process or the cost of raw material. The volume of the product manufactured can also have a direct impact on the overall Cost of Goods Sold.

It is an important figure because you will need it when filing your tax returns. Adding it to the equation will reduce your total income, hence giving you a certain advantage. Unfortunately, calculating this cost of goods sold is not as simple as it sounds. Getting it right is crucial to getting your taxes right.

How Can You Calculate the Cost of Goods Sold?  

Quite naturally, the calculation of the Cost of Goods Sold varies from product to product. There are many factors to consider. It is in the best interest of your business to work with a CPA or a tax professional in order to accurately calculate the cost of your business income tax returns.

The first thing you need is the beginning amount and the inventory amount plus the cost of all the inventory purchased that year. There are different evaluation methods. You should talk to your CPA to know which one they will be using. This will give you a better idea of components you need for the actual calculation.

What Are the Essential Components for the Calculation of the Cost of Goods Sold

The first step is to identify and analyze the following components.

  • Cost of inventory at the beginning of the year
  • Cost of inventory purchased during the year
  • Inventory left at the end of the year

The sum of the first two components minus the last component will get you the Cost of Goods. It doesn’t matter if you are a manufacturer or re-seller, this calculation will help you deduce both the direct and indirect cost of goods sold.

Direct and Indirect Costs – In the next step, direct costs and indirect costs are calculated.

The direct costs include the cost of raw material, cost of merchandise, packaging costs, cost of supplies for production, and direct overhead costs involved in the production.

The indirect costs include labor cost, storage cost, salaries, equipment cost, as well as the cost of depreciation. Facilities costs include mortgage, rent, utilities, etc. This is perhaps the most complicated part of the entire process. It is quite impossible for any business to determine these costs without the help of a CPA.

The LIFO and FIFO Methods

LIFO and FIFO are ways to calculate the inventory that is left at the end of the year. The IRS is very critical of the valuation method you use. In case you decide to use a different valuation method than the previous year, you will need to seek approval from the IRS.

Different COGS calculation forms are used for different types of businesses. For instance, sole proprietors use Part III for calculation and include the cost in income section part I. Corporations or partnerships use the Form 1125A. This may be a complicated process and best left to professional CPAs.

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About Complete Controller® – America’s Bookkeeping Experts Complete Controller is the Nation’s Leader in virtual accounting, providing services to businesses and households alike. Utilizing Complete Controller’s technology, clients gain access to a cloud-hosted desktop where their entire team and tax accountant may access the QuickBooks file and critical financial documents in an efficient and secure environment. Complete Controller’s team of  US based accounting professionals are certified QuickBooksTMProAdvisor’s providing bookkeeping and controller services including training, full or partial-service bookkeeping, cash-flow management, budgeting and forecasting, vendor and receivables management, process and controls advisement, and customized reporting. Offering flat rate pricing, Complete Controller is the most cost effective expert accounting solution for business, family office, trusts, and households of any size or complexity.

 

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Businesses vary greatly in terms of the types of goods and services they provide to consumers and how they produce and deliver those goods and services, but every business has the basic goal of making a profit. Notably, the cost of goods sold is the sum of different costs that are incurred in the product and selling processes of products of an organization. Bookkeeping principles have been defined for recording and summarizing the gross profits and cost of goods sold.

Factors Affecting Gross Profit

Cost of goods (COGS) sold is one of the key elements that influences the gross profit of an organization. The cost of goods sold for a particular service or product refers to the direct costs that are associated with its production, which includes labor necessary to produce the product and materials for the product. Hence, an increase in the cost of goods sold can decrease the gross profit. Since the gross profit comes after the reduction of variable costs from the total revenue, increases in the variable costs can decrease the margin for gross profit. Hence, the greater the cost, the lesser the gross profit.

In addition, cost of goods sold does not include indirect costs that cannot be attributed to the production of a specific product, like advertising and shipping costs. Similarly, it means that the higher the COGS, the lower the gross profit margin. If the COGS exceeds total sales, a company will have a negative gross profit, meaning it is losing money over time and also has a negative gross profit margin.

Calculating the gross profit margin requires calculating gross profit. According to the IRS, gross profit is equal to total receipts or sales minus the value of returned goods and the cost of goods sold. Gross profit margin is equal to gross profit divided by total sales and is often expressed as a percentage. For example, if a company has a gross profit of $500,000 and $1,000,000 in total sales, its gross profit margin is 1/2 or 50%. This means that, for every sales dollar the company takes in, it earns 50 cents of profit.

Total sales or gross receipts is the other key component of gross profit margin. When sales exceed costs by a large amount, gross profit margin will tend to be high, while low sales will tend to result in a low gross profit margin or negative profit. Any factors that can increase sales such as lower tax rates, higher consumer confidence, and effective marketing campaigns can also result in a higher gross profit margin.

Factors Affecting the Cost of Goods Sold

Different factors contribute towards the change in the cost of goods sold. This includes the prices of raw materials, maintenance costs, transportation costs and the regularity of sales or business operations. Meanwhile, inventory as valued plays a considerable in the calculation of the cost of goods sold of an organization. The two most common methodologies for inventory valuation include Last-In-First-Out (LIFO) and First-In-First-Out (FIFO). FIFO carries an assumption that the goods produced first are sold first. This means that, when a firm sells its good, expenses related to the production of the first item are considered.

On the other hand, LIFO carries an assumption that the latest produced goods are the goods that are sold first, whereas, the expense involved in the manufacturing of the last item recognized. Consequently, objects manufactured later are commonly more expensive because they require the materials and labor costs that are in accordance with the existing prices. Thus, LIFO has the tendency to increase the cost of goods sold, which leads to a decrease in income for both reporting and tax purposes. Hence, it can be said that cost of goods is affected by the method through which it is recorded and the changes in the prices of materials and labor costs involved in the production and sales.

In addition to the above, a company can have a lower gross profit compared to another similar company, but still have a higher profit margin. For example, a small company might only have sales of $50,000, but if its cost of goods sold is $25,000, it has a gross profit margin of 50% and $25,000 of gross profit. A large company might have $1,000,000 of sales and $900,000 in costs, which amounts to a gross profit margin of 10% and $100,000 of gross profit.

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About Complete Controller® – America’s Bookkeeping Experts
 Complete Controller is the Nation’s Leader in virtual accounting, providing services to businesses and households alike. Utilizing Complete Controller’s technology, clients gain access to a cloud-hosted desktop where their entire team and tax accountant may access the QuickBooks file and critical financial documents in an efficient and secure environment. Complete Controller’s team of  US based accounting professionals are certified QuickBooksTMProAdvisor’s providing bookkeeping and controller services including training, full or partial-service bookkeeping, cash-flow management, budgeting and forecasting, vendor and receivables management, process and controls advisement, and customized reporting. Offering flat rate pricing, Complete Controller is the most cost effective expert accounting solution for business, family office, trusts, and households of any size or complexity.

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One of the most important reasons that a company may understate its cost of goods sold is to increase its chances of short-term success in a given market. Short-term success can be attained by getting financing or impressing outsiders to finance the company. However, understating the cost of goods sold can be dangerous for the long-term survival of a company if authorities find the fraud. Moreover, understating the cost of goods sold are in direct opposition to bookkeeping standards and rules. The different reasons why a company would understate its cost of goods sold have been discussed below.

Increase in Income

In order to determine the gross profit of a company, the cost of goods sold is subtracted from revenues. The lower the cost of goods sold, the higher the gross profit. Consequently, lower cost of goods sold makes an organization look more effective and efficient. A company stating lower cost of goods sold can create the appearance of a more sustainable business model in a competitive market. A company looking to increase the figure of cost of goods sold may under represent the cost of goods sold to impress potential investors. However, this does not provide an accurate presentation of the balance sheet of an entity and, therefore, can bring legal trouble. Sure, a firm can increase its income by attracting more investors, but the investors and other authorities can sue the company if they find out that the cost of goods sold was understated.

Get Financing

Small businesses often need outside financing to survive and grow in the market. A lower cost of goods sold (COGS) and a more appealing balance sheet may be needed to impress a bank loan officer. Businesses may be tempted to understate their COGS in order to make their business model look more attractive and their profit more sustainable, making them better candidates for loans. A lower COGS makes the financial statements more attractive – at least until it comes time to pay taxes on the earnings. This may impress potential investors and analysts who look only at the documents and do not delve any deeper into the data. The analysis based on provided data – that is, understated cost of goods sold – can provide positive remarks regarding the performance and sustainability of an organization. Therefore, an investor can be convinced to invest their money into the company. Hence, some companies falsely understate the cost of goods sold in order to present their efficiency in the management of cost and achievement of higher profits.

Considerable Risk

Knowingly filing false financial statements puts a company, the signatory to the documents, and perhaps the business owner in legal jeopardy. State and federal agencies watch for irregularities in balance sheets and are increasingly focusing on the raw data used to compile those numbers. Fraudulently lowering the COGS, or altering anything on financial documents, carries considerable risk of fines, prison terms, or both. Even still, although understating cost of goods sold is illegal and risky, there are companies who do so to attract different stakeholders.

Legally Minimizing COGS

Companies can value their inventory in a way that legally minimizes the cost of goods sold, depending on the nature of their business. Using the first-in, first out (FIFO) method determines the COGS by using the costs of your oldest inventory first. Depending on what kind of business it is, this may or may not objectively be the optimum strategy. For example, a business that sells rare coins may have won a particular item for $100 at auction and later spent $1,000 to acquire another one. If the business then sells that coin for $900 as part of a promotion, the FIFO method would result in the company showing an $800 profit, taking the coin that cost $100 to acquire out of inventory. Using the last-in, first-out inventory value method would record the same transaction as a $100 loss by removing the $1,000 coin from inventory.

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About Complete Controller® – America’s Bookkeeping Experts Complete Controller is the Nation’s Leader in virtual accounting, providing services to businesses and households alike. Utilizing Complete Controller’s technology, clients gain access to a cloud-hosted desktop where their entire team and tax accountant may access the QuickBooks file and critical financial documents in an efficient and secure environment. Complete Controller’s team of  US based accounting professionals are certified QuickBooksTMProAdvisor’s providing bookkeeping and controller services including training, full or partial-service bookkeeping, cash-flow management, budgeting and forecasting, vendor and receivables management, process and controls advisement, and customized reporting. Offering flat rate pricing, Complete Controller is the most cost effective expert accounting solution for business, family office, trusts, and households of any size or complexity.

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Manufacturing companies are usually involved in the production and manufacturing of goods. These are large organizations with inventories in various stages of production. Most companies have three inventory accounts. Each inventory requires separate handling for proper calculation of the cost of goods sold. The three types of inventory are:

  • Inventory of raw materials
  • Work in progress inventory
  • The inventory of finished goods

For calculation of the cost of goods sold for a manufacturing company, each of the above inventories needs separate calculations. After calculating one segment, you move on to the next. The systematic calculation of each cost and inventory will eventually lead to the cost of goods sold statement. However, the basic calculation of each cost subhead is similar:

Initial inventory

Add: Other addition to the inventory

Minus: Ending inventory

Equals: Goods transferred from manufacturing

What Costs are Linked to the Cost of Goods Sold Statement?

The essential aspect, which is a must for accountants, is to note and properly label the amount that is transferred out from the account. It is important to write down the terminology. Using correct terms to identify each item is vital for proper calculations.

Inventory of Raw Materials

This inventory is the initial inventory that is placed right at the beginning of the cost of goods sold statement. It includes all the raw materials purchased for manufacturing a specific product. While making the cost of goods sold statement, make sure that all direct and overhead raw material costs are accounted for. After adding all raw materials, subtract the ending inventory from the raw material inventory account towards the end of one period. These materials await for transfer to the work in progress inventory, where the labor costs are included in the statement.

All raw materials left behind after the manufacturing process is complete must be included in the opening inventory of the next period. In the end, the statement will become:

Initial Inventory

Add: All raw material purchased

Less: Ending Inventory

Equals: Total raw material utilized in production

Work in Progress Inventory

The work in progress inventory is the next step in completing the cost of goods sold statement. After adding different materials to the production line, there are three additional production costs. These costs include direct materials, direct labor and overhead costs associated with manufacturing. All three costs are collectively called the “Manufacturing Costs.” The total inventory will be added to the Total Manufacturing costs and from this figure, the ending inventory will be deducted.

The goods that transfer from the work in progress inventory are termed as Finished Goods. These goods are transferred to the finished goods inventory. The equation then becomes:

Initial Inventory

Add: Total Manufacturing Costs

Less: Ending Inventory

Equals: Cost of goods manufactured

The Finished Goods Inventory

The last and most important part of the cost of goods sold statement for a manufacturing company is the Finished Goods Inventory. In this inventory, all goods are transferred from the work in progress inventory to the finished goods inventory. Now the equation becomes:

Initial Inventory

Add: Total Manufacturing Costs

Less: Ending Inventory

Equals: Cost of goods manufactured

Less: Ending inventory

Equals: Cost of Goods Sold

The final inventory includes all goods that are sold off after the entire process of goods transfer and manufacturing is complete. Only the final products are sold off as final finished products. A more detailed statement includes overhead costs and other costs.

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About Complete Controller® – America’s Bookkeeping Experts Complete Controller is the Nation’s Leader in virtual accounting, providing services to businesses and households alike. Utilizing Complete Controller’s technology, clients gain access to a cloud-hosted desktop where their entire team and tax accountant may access the QuickBooks file and critical financial documents in an efficient and secure environment. Complete Controller’s team of  US based accounting professionals are certified QuickBooksTMProAdvisor’s providing bookkeeping and controller services including training, full or partial-service bookkeeping, cash-flow management, budgeting and forecasting, vendor and receivables management, process and controls advisement, and customized reporting. Offering flat rate pricing, Complete Controller is the most cost effective expert accounting solution for business, family office, trusts, and households of any size or complexity.

 

 

 

 

 

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Cost of goods sold is the calculation of the value of any company’s inventory which has been sold and the things which have not been sold or will be sold in the future. It is shown similarly on every type of business tax return. On each return, the cost of goods sold is considered as a reduction in business income. Therefore, the higher you can legitimately make the cost of the goods sold, the lesser income you will have to pay taxes on. The calculation process of the goods sold is the same for all businesses.

How to Calculate Cost of Goods Sold

  • Gather the information needed for this calculation. Mostly, you will need to know the valuation method, beginning and ending inventory, and the cost of labor and purchases.
  • You should be doing the calculation which starts with beginning inventory, adding in the cost of materials, labor and other costs during the end and then finally calculating the ending inventory.

The calculation of the cost of goods sold depends on the tax returns. The cost of goods sold is important for every business as it is an allowable deduction on taxes. If a business fails to add this value, their business income becomes higher than necessary which means higher taxes.

Consider the Following Information

  • Valuation Method: Designate whether inventory is valued equally to the cost of the market, lower than the cost of market or other. If you are using the cash accounting method, make sure that you value inventory at cost. Also make sure that your tax preparer is under constant check especially if you have changed your method of determining quantities, values or costs. You should be including an explanation of any changes to make the tax preparer and your employees aware.
  • Beginning Inventory: This is the total cost of all products in your inventory at the beginning of any year. Most of the time, this should be the same as the inventory at the end of the year. If it is not the same, you must provide an explanation.
  • Cost of Purchasing: You should be able to get a total of all the products that you purchased during the year and those items that you placed in the inventory to sell. You should subtract any products that you took out for your personal use. In case you are a manufacturer, you will need to include the total cost of all the raw materials and parts that you purchased during the time of that one year. It does not matter if they were assembled or not.
  • Cost of Labor: This is the cost of your business employees who directly work in making products from raw materials and parts. It does not include costs for administrators or employees in sales, marketing, finance or other areas that a business consists of.
  • Costs of Materials and Supplies: These costs should be directly in relation to making the product.
  • Other Costs: These include your shipping costs, freight-in on materials and the supplies, and the overhead expenses for rent, heat, light, etc. for the area where the products are being manufactured, produced, or assembled.
  • Ending Inventory: Calculate and determine the total value of all items in inventory at the end of the year.

This is basically everything that you need in order to calculate the cost of goods sold using a tax software program or to give to your tax preparer that you have employed. Always make sure that you can provide records verifying the costs of goods sold.

Summary of How to Calculate the Cost of Goods Sold

  • Add up beginning inventory, purchases and all the other costs.
  • Getting costs of the goods sold.
  • Subtract the inventory at the end of the year.

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About Complete Controller® – America’s Bookkeeping Experts Complete Controller is the Nation’s Leader in virtual accounting, providing services to businesses and households alike. Utilizing Complete Controller’s technology, clients gain access to a cloud-hosted desktop where their entire team and tax accountant may access the QuickBooks file and critical financial documents in an efficient and secure environment. Complete Controller’s team of  US based accounting professionals are certified QuickBooksTMProAdvisor’s providing bookkeeping and controller services including training, full or partial-service bookkeeping, cash-flow management, budgeting and forecasting, vendor and receivables management, process and controls advisement, and customized reporting. Offering flat rate pricing, Complete Controller is the most cost effective expert accounting solution for business, family office, trusts, and households of any size or complexity.