Let’s review the traditional cogs equation. It’s very easy to understand.
I call this the old-fashioned way to compute cogs since it’s not the formula used by modern accounting software such as QuickBooks, which relies on the perpetual inventory system. Even though it seems old fashioned, it’s a good formula to memorize.
The cogs equation’s final result does not include inventory that was unsold at the end of the period. Purchased inventory is not written off until it is sold, which may be immediately, or may be quite a long time later. Unsold inventory is an asset on the Balance Sheet. The final result of the cogs equation only includes inventory that was sold during the period, hence the name cost of goods sold.
Firms that use periodic inventory use this formula regularly. Page two of the 1040 Schedule C (the tax return for sole-proprietors) shows the cogs equation clearly.
Here is how the cogs equation works.
- Begin at the beginning of the year (or other period). The total cost your beginning inventory. This should be the same as the cost of the ending inventory for the prior year. New businesses have a beginning inventory balance of zero.
- Add the cost of inventory purchased during the year.
- For manufacturers, add wages paid to people who actually worked to manufacture the goods.
- Add the cost of other materials and supplies that are directly used in or on the products.
- Add in other direct costs associated with the sale.
- Subtract the cost of personally used items.
- Subtract the cost of ending inventory.
The result is the cost of goods sold. This is the dollar value of the inventory that was sold during the period. I’ve often seen people write off inventory to the Income Statement when it was purchased, but this is incorrect. Purchased inventory goes on the Balance Sheet, where it stays until it gets sold. It goes to the Income Statement only after it has been sold.
There are different ways to value inventory. The Schedule C offers three choices: cost, lower of cost or market, or other. There is also FIFO (first in, first out), LIFO (last in, first out), and average cost. QuickBooks doesn’t use the cogs equation, because it is a perpetual inventory system. It uses average cost to value the inventory on the books.
When using QuickBooks, inventory is placed on the Balance Sheet via one of the three purchase windows, using the Items tab. Inventory remains on the Balance Sheet until an Invoice or Sales Receipt is created for a customer. Once this happens, QuickBooks computes cogs by taking the average cost information of the sold inventory items, and moves it from the Balance Sheet to the Income Statement as of the date of the invoice. The revenue that was created by the sale of the inventory is “matched” with the write-off of that inventory as of the date of the sale. This allows for very accurate financial reporting – you can generate an Income Statement for a single day and get accurate cogs information.
With modern accounting technology such as QuickBooks, more and more firms are moving to the perpetual inventory system. Even so, the cogs equation is still good to know because:
- It can provide users of perpetual inventory with a back-up way to verify their cost of goods sold and their inventory asset balance.
- It is the only way cost of goods sold and ending inventory can be calculated under the periodic method.