Business means buying and selling of goods. So it is needless to say how important Inventory is for the business. When talking about Inventory many things come to our mind. How do you value inventory? What are the inventory costs etc.? One of the costs related to inventory is Cost of Goods Sold.
Read below to understand more on COGS
Cost of Goods Sold is the direct cost of the goods sold to customers. Cost of goods sold (COGS) are the direct costs attributable to the production of the goods sold by a company. This amount includes the cost of the materials used in creating the good along with the direct labor costs used to produce the good. It excludes indirect expenses such as distribution costs and sales force costs. COGS appears on the income statement and can be deducted from revenue to calculate a company’s gross margin.
To compute the cost of goods sold, start with the cost of beginning inventory of goods, add the
cost of goods purchased, and then subtract the cost of ending inventory of goods.
Assume that value of beginning inventory is AED 3,000. Purchases made during the year amounts to AED 1,500 and the closing inventory is valued at AED 1,000. In this case the COGS will be equal to AED 3,500 (3,000+1,500-1,000).
If the beginning inventory is understated to AED 2,500, other things remaining the same, then the value of COGS will be reduced to AED 3,000 (2,500+1,500-1,000)
Therefore any error in the recording of beginning inventory or closing inventory will result in the changes in the value of COGS accordingly.
Since both Beginning and ending inventory appears in the Income Statement any errors made while recording these items can have a significant impact on the Profit or Loss ascertained by the Income Statement. If a company understates its beginning inventory, profit will be overstated because the cost of goods sold will be on a lower side whereas if the beginning inventory is overstated it will result in higher COGS leading to understatement of profit. Similarly if a company understates its ending inventory, profit will be understated because the cost of goods sold will be higher and if a company overstates its ending inventory, profit will be overstated because the cost of goods sold will lower.
The purpose of the COGS calculation is to measure the true cost of producing goodsand COGS can also be an important tool for management because it helps them analyse how well purchasing costs are being controlled. When used properly, COGS is a useful calculation for both management and external users to evaluate how well the company is purchasing and selling its inventory.