COST OF GOODS SOLD:

The above example dealt with a business that generated revenue through rentals. Moreover, the TRY OUR BIKES company purchased an inventory of bicycles and safety equipment and rented them to customers. Never does the company's customers own the rented items. In other words, at the end of the day, customers return the bicycles and safety equipment to the rental company. Most businesses, however are not structured in this manner. For instance, retail clothing outlets purchase clothing from their suppliers and sell it to end consumers (You & I). When we, as consumers, purchase clothing, we own the clothing and do not have to give it back. If you are establishing a business that transfers ownership of goods/products, from your business to the customer, then you will be required to use an account called Cost of Goods Sold (COGS).

As the name implies, the Cost of Goods Sold tracks or tallies all the costs of all products sold. Furthermore, a business can only recognize, as an expense, the costs of the products it sells. Unsold products are still owned by the business and considered inventory under the Asset section of the Balance Sheet.

To illustrate the cost of goods sold account, lets assume on March 1, 200X Mary Parker opened a retail clothing outlet called MRS. BLUE. The only product she sells is blue jeans. She purchases the blue jeans from a wholesaler in Washington. The jeans cost Mary $20.00 each (including shipping) and she sells them at retail (to you and I) for $50.00 each. Mary and her accountant decided the company's year end will be December 31 of each year. Lets further assume, today's date is December 31,200X (the company's year end). Mary presents her accountant with the following information.

1. From March 1 to December 31 (200X), the company sold 5,000 pair of blue jeans at $50.00 each.

2. Each pair of jeans cost $20.00 including shipping.

3. From March 1 to December 31, 200X Mary's company incurred the following operating expenses.

Given the above information, we can develop an Income statement for the MRS. BLUE company for the year ending December 31, 200X. Assume an income tax rate of 40%.

Notice the Cost of Goods Sold account shows a balance of $100,000. This was arrived at by multiplying the number of blue jeans sold (5,000 pairs) by the cost to purchase and ship each pair of jeans ($20). Three important points to remember when calculating cost of goods sold are;

1. It doesn't matter whether Mary PAID her supplier for the jeans she sold. Unpaid items are considered Liabilities; and liabilities appear on the Balance Sheet - not the income statement; and

2. It doesn't matter how many pairs of jeans Mary's company purchased during the year. Mary may have purchased 15,000 pairs of jeans from March 1 up to December 31, however, rules have been developed in accounting which disallow her to expense (cost of goods sold) the full 15,000 pair of jeans. In other words, Mary is only allowed to expense the jeans in which her company has sold. Hence, Cost of Goods Sold. The remaining 10,000 pair of jeans would be classified as inventory under the Assets section of the Balance Sheet.

3. Remember shipping and handling changes are always part of the cost of goods sold, regardless of the type of business you are operating.

Specific calculation of your Cost of Goods Sold will depend on whether you are a manufacturer, a retailer, or a service provider. For instance, most retailers and service providers purchase products that are considered finished and ready for the public to purchase. In other words, when suppliers ship products to retailers and service providers, they require little, if any, alterations before they are sold to customers. Therefore, if you are a retailer or service provider that sells finished products, you will calculate your Cost of Goods Sold using the cost of the product plus shipping costs. Since Mary Parker is a retailer and sells finished products, she will use these two items to calculate her Cost of Goods Sold. If you are manufacturing a product, however, you are obligated to make several alterations to the product (raw materials) before it can be made available to buyers. Moreover, manufacturers must buy raw materials, have the raw materials shipped to their business, pay employees to alter the raw materials into finished products and incur factory overhead costs. Therefore, manufacturers would use these four cost items in calculating their Cost of Goods Sold.   Please Note: Factory Overhead is simply, production facility costs or expenses that a business incurs when transforming their raw materials into finished products. Factory overhead costs (production facility costs) may include heat, electricity, general maintenance supplies, and other costs that apply directly to the production facility. Below is a summary of items that should be considered when calculating the Cost Of Goods Sold for a manufacturer and a Retailer/Service business.

For additional information on how to calculate Cost of Goods Sold, please refer to the section entitled "Developing Your Cost of Goods Sold Budget"