Cost of Goods Sold: Debit or Credit? (A COGS Overview)

For businesses managing their accounting, calculating the Cost of Goods Sold (COGS) is a key concept to learn and implement.

For a short introduction, the Cost of Goods Sold represents the direct costs of producing goods sold by a business. With some confusion on how to calculate it, the question often arises: 

Is COGS a debit or credit? 

Let's clarify this right away. COGS is a debit entry because it's an expense on your business's financial statement.

In this article, we will explore COGS, how to calculate it, and the step-by-step process of making a journal entry.

Let's start!

Key Takeaways

• Learn whether COGS is a debit or credit in your accounts
• Step-by-step walkthrough to creating a COGS and operating expenses journal entry
• Understand the impact of COGS on income statement
• Learn why COGS is important in direct costs incurred and the business decision-making process
• Know the difference between the Cost of Sales and the Cost of Goods Sold
• Gain additional advice on how to avoid common mistakes in direct costs incurred, operating expenses, and overhead costs

Is Cost of Goods Sold a Debit or Credit? 

COGS represents the direct costs attributable to producing goods a company sells. 

Before discussing the direct cost and indirect cost of goods sold in a journal entry, it's important to know how to calculate COGS. Follow this formula to determine your COGS:

COGS = Your Beginning inventory + Purchases during the period – Ending inventory

It usually includes the cost of materials, labor, and overhead directly associated with production. 

Accurately recording COGS is necessary for two main reasons. 

Firstly, it allows businesses to determine their gross profit accurately, which is vital for assessing profitability. 

Additionally, proper COGS recording ensures compliance management with accounting standards and provides stakeholders with reliable financial information for decision-making.

We will discuss how COGS impact your financial statements and business decision-making in more detail, but let's first review the COGS journal entry process in your accounts book.

Step-by-Step Guide to Make Cost of Goods Sold Journal Entry

Here's a simple 3-step guide to making a Cost of Goods Sold journal entry effective:

Step 1: Identify the Cost of Goods Sold

As the first part of this step, ensure you have all raw materials inventory, your related expenses, and information about additional inventory available. Collect important information such as your inventory balance before sales, purchased inventory's total cost, overhead costs (e.g., delivery fees, returns, shipping costs, etc.), and ending inventory balance for the term.

Next, calculate COGS by subtracting the cost of ending inventory from the sum of beginning inventory and purchases during the accounting period (the formula above). 

This calculation provides the total cost of goods sold during any period you use as a reference.

Step 2: Record the COGS as a Debit Entry

The most important part is understanding Debit and Credit in COGS.

Ensure your COGS is recorded as a debit entry because it represents an expense your business faces when generating revenue. Debit the COGS account to increase expenses and reduce net income.

Step 3: Record the Corresponding Accounts

To ensure we have the correct ending inventory, use this example.

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Ending Inventory = Beginning Inventory + Purchases - COGS

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Let’s break this down:

• Beginning Inventory is the value of inventory at the start of the accounting period
• Purchases are the costs of buying or producing additional inventory during the period
• Cost of Goods Sold is the cost of the inventory items that were sold to customers during the period

So, if you know the beginning inventory balance, the purchases made during the period, and the COGS, you can calculate the ending inventory by taking the beginning balance, adding purchases, and subtracting COGS.

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For example, if a company had:

• Beginning Inventory: $20,000
• Purchases: $5,000
• COGS: $12,000

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The ending inventory would be:

• $20,000 + $5,000 - $12,000 = $13,000

Understanding the Impact of COGS on Financial Statements 

The cost of goods sold impacts financial statements, influencing profitability and asset valuation. 

Let's explore how COGS shapes financial statements and what it means for a business in the wider context.

COGS and Gross Profit

COGS is subtracted from revenue to calculate gross profit. 

Gross Profit = Revenue – Cost of Goods Sold 

This simple equation tells us a lot about a company's performance. 

Here's how it works:

• Higher COGS, Lower Gross Profit: When COGS is high, a large portion of revenue is spent on producing goods. As a result, gross profit decreases, indicating lower profitability for the company.
• Gross Profit as Efficiency Indicator: Gross profit indicates how efficiently a company's production process and pricing strategy work. A higher gross profit suggests that a company effectively manages its production costs and pricing its products competitively.

COGS and the Balance Sheet

COGS also affects the balance sheet by influencing the valuation of inventory, which is an asset. 

Here's how:

• Reduction in Inventory: When goods are sold, their cost is transferred from the inventory account to the COGS expense account. This reduces the inventory value on the balance sheet, reflecting the conversion of assets (inventory) into revenue-generating activities.

• Changes in Asset Valuation: The reduction in inventory due to COGS directly impacts the asset side of the balance sheet. A decreased inventory value means fewer assets are available for the company, affecting financial ratios and overall financial health.

Practical Example of COGS Entries

Consider a scenario where a retail store sells $10,000 worth of merchandise with a COGS of more than $6,000. The journal entry to record this transaction would be:

For the same store, let's take another example. 

For the month, your Beginning Inventory Balance was $5000. You made more purchases for $1200 during this time, and by the end of the month, your Closing Inventory Balance was $800.

First, calculate COGS using the formula ($5000 + $1200 – $800) and get $5400.

Secondly, the inventory ($5400 – $1200) is calculated, resulting in $4200.

The account entry would look like this:

Common Mistakes to Avoid When Calculating COGS 

Now, let's address common mistakes that small businesses may encounter when recording COGS entries:

Misinterpreting Included Costs

One common mistake is misinterpreting the costs included in COGS. Businesses must ensure that COGS includes only direct costs directly attributable to producing goods, such as raw materials, and the direct expenses incurred for labor costs.

Failing to Adjust for Inventory Shrinkage or Spoilage

Inventory shrinkage or spoilage can distort COGS calculations if not properly accounted for. Businesses should regularly monitor inventory levels and adjust COGS to account for any losses due to shrinkage or spoilage.

Neglecting to Update Inventory Valuation Methods

Changes in inventory valuation methods, such as moving from FIFO (First-In-First-Out) to LIFO (Last-In-First-Out), can impact COGS calculations. Neglecting to update inventory valuation methods can result in inaccuracies in COGS reporting.

By the end of this article, we'll discuss why it's important to calculate COGS accurately for your business and its consequences. 

But before that, an important clarification!

Difference between Cost of Sales and Cost of Goods Sold 

While Cost of Goods Sold and Cost of Sales are often used interchangeably, there are key differences that you should know as a professional:

• COGS specifically refers to the direct costs associated with producing goods, while Cost of Sales covers direct and indirect costs related to sales activities.  
• COGS is mainly used in manufacturing and production industries, whereas Cost of Sales is more commonly used in service-oriented businesses.
• COGS appears on the income statement, while Cost of Sales may include additional expenses like distribution, HR and payroll management, and marketing costs.

This is the simplest way to remember the differences. In accounting, COGS is calculated more for product-based sales, and Cost of Sales is more for service-based businesses.

The Role of COGS in Business Decision Making 

But why is all that effort needed when accounting only costs are for the Cost of Sales?

Well COGS is an essential calculation tool for making informed business decisions. It is a critical metric directly impacting various aspects of a company's operations, including pricing strategies and inventory management.

Relationship Between COGS and Pricing Strategies

COGS plays a fundamental role in determining businesses' pricing strategies. By accurately calculating COGS, companies can set prices that ensure profitability while remaining competitive. 

Here's how COGS influences pricing decisions:

Cost Recovery

Pricing decisions aim to recover variable costs (directly associated with marketing expenses along with producing finished goods themselves) and fixed costs (overhead expenses). Understanding COGS allows businesses to factor in these costs when setting prices to ensure that each sale covers expenses and generates profit.

Profit Margin Calculation

COGS is subtracted from revenue to calculate gross profit, which represents the money left after covering the direct costs of goods sold. Businesses can use their gross margins and profit margins to assess the profitability of their products and adjust pricing strategies accordingly.

Competitive Positioning

Knowledge of COGS enables businesses to evaluate their cost structure relative to competitors. By understanding how their COGS compares to industry benchmarks, companies can adjust pricing strategies to maintain profitability while remaining competitive.

Impact of COGS on Inventory Management

COGS also has a significant impact on inventory management practices. Efficient management of inventory levels is crucial for optimizing cash flow, reducing carrying costs, and preventing stockouts. 

Here's how COGS influences inventory management decisions:

Optimal Inventory Levels

Understanding COGS helps businesses determine the optimal level of inventory to maintain. By analyzing historical COGS data and demand patterns, companies can forecast future inventory needs and avoid overstocking or understocking situations.

Inventory Valuation

Now you know that COGS affects the inventory valuation on the balance sheet. Proper inventory valuation methods also ensure that inventory reflects its true economic value, which is essential for financial reporting and business decision-making.

Cost Control Measures

Monitoring COGS allows businesses to identify opportunities for cost-saving measures in the production process. By analyzing COGS components such as raw materials inventory and labor costs, companies can implement strategies to reduce production expenses and improve overall profitability.

Frequently Asked Questions about COGS

What happens if COGS is incorrectly recorded? 

Incorrect COGS entries can distort financial statements, leading to inaccurate profitability assessments and poor decision-making. It can also result in overstated gross profit and net income, impacting the company's perceived financial health and potential investor confidence.

Can COGS be a credit entry? 

While COGS is typically recorded as a debit entry, there are scenarios where it might appear as a credit entry. For example, adjusting or reversing previously recorded COGS could result in a credit accounting entry to reduce the expense.

Additionally, if inventory is returned to suppliers, it could result in a credit entry to decrease COGS.

How does COGS affect tax calculations? 

COGS is a deductible expense for tax purposes, reducing taxable income and lowering the tax burden on businesses. By subtracting COGS from revenue, businesses can determine their full gross margin or profit, which is the starting point for calculating taxable income.

A full gross margin and lower COGS result in higher taxable income, while a higher COGS reduces taxable income and tax liability.

How is COGS calculated in a manufacturing company? 

A manufacturing company is a product-based business. As demonstrated above, COGS includes the direct and indirect costs of producing finished goods. It involves tracking inventory purchases, production costs, and any additional expenses directly attributable to the production and manufacturing process.

For service-based businesses, different expenses are calculated as part of the Cost of Sales, not COGS.

Final Word

Understanding and accurately recording COGS is vital for financial reporting, decision-making, business administration, and tax compliance. By following proper accounting practices and seeking assistance from qualified professionals, businesses can ensure transparency, accuracy, and efficiency in their financial operations.

Alternatively, outsourcing these financial calculations to experts can save your business a lot of time and money; good financial advice and accurate accounting can even make you more. 

For expert guidance on accounting matters, partner with Knit, a trusted provider of accounting solutions and software to make keeping track of COGS and all other financial statements simpler and more effective for your business.