Cost of goods sold is a financial accounting term that represents the portion of a business’ net income attributable to goods that were purchased as inventory and later sold to customers or clients. The cost to the business is the actual price that was paid to the manufacturer for the items. It’s an important part of most business income statements; in many places it has tax consequences, and can also help business leaders maximize profit margins and markups. By calculating the cost of all goods that have been purchased from a manufacturer and then resold, a business can figure out its gross profit on sales, and ultimately its net income. Calculation is usually pretty straightforward, and typically follows a simple formula. Manufacturers usually have to work a little bit harder to come up with a figure to represent the total cost of the things sold, usually at wholesale, though it can be done.
Businesses engaged in sales usually need to keep careful track of all of their expenses in order to remain profitable. This is especially true for companies that buy goods for resale. A careful understanding of exactly how much was spent on those goods at the outset can help executives determine how much to sell them for, and can help inform other spending.
How It’s Calculated
There is a basic formula involved in calculating the cost of goods sold. Opening inventory, purchases, cost of goods available for sale, and ending inventory values are needed to come up with the figure on the income statement. The opening inventory is added to the purchases to arrive at the cost of goods available for sale — this is the cost to the business of all products offered for sale to its customers. Closing inventory value — the value of unsold stock still on hand at the end of the accounting period — is then subtracted from the cost of goods available for sale. The resulting figure is cost of goods sold — what it cost the business to sell the products customers purchased during this period.
Sometimes other elements are part of the formula. These other elements include purchase returns and allowances. Other possible elements include purchase discounts and transportation-in.
Purchase Returns and Allowances
Purchase returns and allowances occur when a business returns merchandise that has already been purchased because it deems the products to be unsatisfactory. Alternatively, the business may ask for a price allowance on the merchandise. Purchase discounts can occur when a business receives a cash discount for paying promptly for goods purchased on credit. Transportation-in is the transportation charges a business may pay to bring the goods to its premises.
Consequently, a modified cost of goods formula results. The modification is in the purchases portion of the equation. To arrive at a true purchase figure, a business would deduct any purchase returns and allowances, and purchase discounts it received from a supplier. Next, it would add in any transportation charges it paid to get the goods to its door. This becomes the real cost of purchases.
Special Considerations for Manufacturers
Things are often a bit more complicated for manufacturers, the ones who are actually making the goods in the first place. For a manufacturing business, its cost of goods sold is its cost of manufacturing — the cost of materials and labor required to make a product. This figure tells a manufacturing enterprise what it cost to create a product that it will sell to a go-between entity, such as a wholesaler or retailer. These entities then resell the product to other businesses or consumers, who are the end users of the product. Things like material costs and labor are often part of the calculation.