Understanding COGS, Inventory, and Financial Statements
Key Financial Concepts: COGS, Inventory, and Statements
Sales revenue less COGS (Cost of Goods Sold) is called gross profit. Gross profit less operating expenses equals net income. Operating expenses appear on both income statements of merchandising and service companies. COGS appears on both single and multiple-step income statements.
Single-Step vs. Multiple-Step Income Statements
A single-step income statement reports sales revenue and other revenues and gains in the revenues section. Sales Returns & Allowances and Sales Discounts are contra-revenue accounts. A multiple-step income statement shows gross profit, cost of goods sold, and sales revenue.
Inventory Valuation and Reporting
In the balance sheet, ending merchandise inventory is reported in current assets immediately following accounts receivable. Inventory items on an assembly line in various stages of production are classified as work in progress.
When the terms of sale are:
- Understated beginning inventory: COGS is understated, Net Income is overstated.
- Overstated beginning inventory: COGS is overstated, Net Income is understated.
- Understated ending inventory: COGS is overstated, Net Income is understated.
- Overstated ending inventory: COGS is understated, Net Income is overstated.
Inventory turnover = COGS / Average Inventory. Days in Inventory = 365 / Inventory turnover. COGA (Cost of Goods Available) has two elements: beginning inventory and the cost of goods purchased. Merchandise is recorded by debiting the asset Inventory account. Two entries are required to record each sale: one to recognize sales revenue and the second to record the cost of goods sold. This second entry consists of a debit to Cost of Goods Sold and a credit to Inventory.
The LIFO reserve is an account used to bridge the gap between FIFO and LIFO costs when a company is using FIFO but would like to report LIFO in its financial statements.
Inventory Costing Methods
- Specific Identification: Carries items on your books at their actual cost. Typically used for expensive, unique items.
- Weighted Average: Used when products are physically indistinguishable or easily substituted, like commodities. Every unit in inventory is priced using an average of the cost of all items in inventory.
Consigned Goods and Retail Method
The consignor is the party holding legal ownership/title to the consigned goods. Consigned goods should be included in the inventory of the consignor. The retail method can be used by retailers who have their merchandise records in both cost and retail selling prices. The Goods Available amounts are used to compute the cost-to-retail ratio.
Temporary vs. Permanent Accounts
A temporary account is a general ledger account that begins each accounting year with a zero balance. At the end of the accounting year, any balance in the account will be transferred to another account. This is referred to as closing the account. Permanent accounts are all of the balance sheet accounts (asset accounts, liability accounts, owner’s equity accounts).
Calculating Gross Profit Margin and COGS
Gross profit margin is calculated by subtracting the cost of goods sold (COGS) from total revenue and dividing that number by total revenue.
To find COGS for periodic inventory:
- Beginning inventory + Purchases = Cost of goods available for sale.
- Cost of goods available for sale – Ending inventory = Cost of goods sold.
Lower of Cost or Market (LCM)
LCM is the lower of cost or replacement cost, with the replacement cost being no higher than Net Realizable Value (NRV) and no lower than NRV minus the normal profit.