Discussion: Cost of Goods Sold (COGS)
Profit on sales (gross profit) is Sales minus Cost of Goods Sold (or Cost of Sales). There are two basic methods for calculating Cost of Goods Sold for a period:
- Adding the individual cost of every item sold; or
Stock on Hand at the Beginning of the Period
minus Stock on Hand at the End of the Period
In principle these methods yield exactly the same result to the penny, but the technique to use depends on the reporting context.
- When using sales-based reporting (such as a sales report in Accounts Receivable), the reports have no knowledge of the opening stock, closing stock or other purchases made during the period. They only know what was sold and the cost of those items.
- When using transaction-based reporting (such as a Financial Statement in a General Ledger), the reports are only aware of transactions, such as sales and purchases. In this context, the cost of the items sold is not a transaction and does not appear in the report. Only the invoice total is a transaction. Of course the cost element comes from purchases. The picture is then completed by incorporating the period's opening and closing stock. Closing stock is unsold stock and its value is pushed into the cost of goods sold for the next period.
You purchase 4,550 hammers at $7.21 each (total purchases $32,805.50). 780 are sold at $15.22 (total sales $11,871.60).
- The sales-based report shows sales of $11,871.60 with cost of sales $5,623.80 leaving a gross profit of $6,247.80.
- The transaction-based report shows sales of $11,871.60 with purchases of $32,805.50, leaving a loss of $20,933.90. However, adding back the stock on hand of $27,181.70 (3,770 hammers), this becomes a gross profit of $6,247.80.
In the next period, you purchase no additional stock but sell a further 960 hammers.
- The sales-based report shows sales of $14,611.20, with cost of sales $6,921.60 leaving a gross profit of $7,689.60.
- The transaction-based report shows sales of $14,611.20 with purchases of $0.00, leaving a gross profit of $14,611.20. However, the closing stock from the previous period becomes opening stock in this period, which contributes to the cost of sales. Thus the cost of sales is opening stock of $27,181.70 less closing stock of $20,260.10 (2,810 hammers) = $6,921.60, leaving a gross profit of $7,689.60.
- COGS = Opening Stock + Purchases − Closing Stock
- Purchases = COGS − Opening Stock + Closing Stock
- Closing Stock = Opening Stock + Purchases − COGS
- Opening Stock = COGS − Purchases + Closing Stock