## How a Manufacturing Company Calculates Cost of Goods Sold

Manufacturing companies are usually involved in the production and manufacturing of goods. These are large organizations with inventories in various stages of production. Most companies have three inventory accounts. Each inventory requires separate handling for proper calculation of the cost of goods sold. The three types of inventory are:

• Inventory of raw materials
• Work in progress inventory
• The inventory of finished goods

For calculation of the cost of goods sold for a manufacturing company, each of the above inventories needs separate calculations. After calculating one segment, you move on to the next. The systematic calculation of each cost and inventory will eventually lead to the cost of goods sold statement. However, the basic calculation of each cost subhead is similar:

Initial inventory

Minus: Ending inventory

Equals: Goods transferred from manufacturing

# What Costs are Linked to the Cost of Goods Sold Statement?

The essential aspect, which is a must for accountants, is to note and properly label the amount that is transferred out from the account. It is important to write down the terminology. Using correct terms to identify each item is vital for proper calculations.

## Inventory of Raw Materials

This inventory is the initial inventory that is placed right at the beginning of the cost of goods sold statement. It includes all the raw materials purchased for manufacturing a specific product. While making the cost of goods sold statement, make sure that all direct and overhead raw material costs are accounted for. After adding all raw materials, subtract the ending inventory from the raw material inventory account towards the end of one period. These materials await for transfer to the work in progress inventory, where the labor costs are included in the statement.

All raw materials left behind after the manufacturing process is complete must be included in the opening inventory of the next period. In the end, the statement will become:

Initial Inventory

Less: Ending Inventory

Equals: Total raw material utilized in production

## Work in Progress Inventory

The work in progress inventory is the next step in completing the cost of goods sold statement. After adding different materials to the production line, there are three additional production costs. These costs include direct materials, direct labor and overhead costs associated with manufacturing. All three costs are collectively called the “Manufacturing Costs.” The total inventory will be added to the Total Manufacturing costs and from this figure, the ending inventory will be deducted.

The goods that transfer from the work in progress inventory are termed as Finished Goods. These goods are transferred to the finished goods inventory. The equation then becomes:

Initial Inventory

Less: Ending Inventory

Equals: Cost of goods manufactured

## The Finished Goods Inventory

The last and most important part of the cost of goods sold statement for a manufacturing company is the Finished Goods Inventory. In this inventory, all goods are transferred from the work in progress inventory to the finished goods inventory. Now the equation becomes:

Initial Inventory

Less: Ending Inventory

Equals: Cost of goods manufactured

Less: Ending inventory

Equals: Cost of Goods Sold

The final inventory includes all goods that are sold off after the entire process of goods transfer and manufacturing is complete. Only the final products are sold off as final finished products. A more detailed statement includes overhead costs and other costs.

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# Inventory

Companies that are involved in the manufacturing and selling of physical goods are required to record them as assets in their books and expenses at the time of their sale. Manufacturing companies usually deal with three different kinds of inventories which are materials, work in process and finished goods. Retailers only have to deal with one inventory which is merchandise. In all cases, a company has to sell inventories in order to make profits. Before it is sold, it serves as an asset for the company, however, after merchandise is sold, the cost coverts into an expense, called Cost of Goods Sold (COGS). The cost is then transferred from a balance sheet to an income statement via journal entry in bookkeeping terms.

Companies maintain a significant amount of inventory to manage their day to day operations. However, it is an important asset which needs to be monitored closely. Storing too much inventory can cause issues related to decreasing cash flows, storage costs and losses in case the item turns archaic. Similarly, too little of it can result in lost sales and customers.

Indirect costs or overhead costs that cover depreciation, factory maintenance, cost of factory management, electricity, etc. are allocated to inventory, depending on the production levels. Overheads are frequently assigned based on direct labor hours or a number of machine hours.

# Cost of Goods Sold

Cost of Goods Sold basically represents the cost of goods or merchandise that has been sold to customers. Unlike inventory, which is mentioned on the balance sheet, cost of goods is reported on the income statement. All of the costs that are occurred in order to get the merchandise into the inventory and then ready for sale are included in the cost of goods. The cost of acquiring it from the supplier, shipping costs, and all other costs are included. Direct materials, labor, and overhead costs are also included in the cost of goods sold.

For services, the cost of goods would account for labor, payrolls, and benefits. Basically, all of the direct costs that are associated with the production of the product is the cost of goods. It is important to highlight that goods that are not sold during the year and are still in inventory would not be included to calculate the COGS. Only the goods that were sold are included.

# Cost Flow Assumptions

There are basically three methods that are accepted by the IRS to move the cost from the balance sheet to the income statement. FIFO (First In First Out), LIFO (Last In First Out) and Average Cost are the accepted methods. They are exactly what the names suggest. First in first out means that goods that arrive first should be removed first at an original cost. It doesn’t matter if the cost of goods sold has increased for the new batch, you would have to record at an original price.

Each cash flow assumption can be used in both of the systems mentioned below.

## Periodic Inventory System

Under the periodic system, the amount in the inventories account is not updated at the time of purchase. In fact, the account is only updated at the end of a year. This means that for the whole year the account would show the cost of last year’s stock.

All the purchases related to merchandise are recorded in either one or more purchase accounts. At the time of year-end, the purchase accounts are closed and the stock account is matched with the cost of merchandise at hand. Under the periodic system, cost of goods sold does not exist in the account to record the sale of merchandise. It is simply calculated as beginning stock + new purchases – ending stock. You would not be able to calculate it while looking at a general ledger account.

## Perpetual Inventory System

Under a perpetual system, the stock account is continuously updated. The cost of merchandise that is purchased from the suppliers is added to the account, while what is sold to the customers is continuously being reduced from the account. There is no room for purchase accounts under this system.

The cost of goods sold account is debited at the time of the sale, exactly for the cost associated with the merchandise. For the sale of any merchandise, there have to be two recorded journal entries. Sales and accounts receivable are recorded as one entry while the other caters to the reduction of inventory and increase in the cost of goods that are sold.

FIFO, LIFO and Average cash flow assumptions are combined with either perpetual or periodic systems to account for the cost of stock at hand. It is up to you to choose any one of them at your convenience.

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## Why Would a Company Understate Cost of Goods Sold?

One of the most important reasons that a company may understate its cost of goods sold is to increase its chances of short-term success in a given market. Short-term success can be attained by getting financing or impressing outsiders to finance the company. However, understating the cost of goods sold can be dangerous for the long-term survival of a company if authorities find the fraud. Moreover, understating the cost of goods sold are in direct opposition to bookkeeping standards and rules. The different reasons why a company would understate its cost of goods sold have been discussed below.

# Increase in Income

In order to determine the gross profit of a company, the cost of goods sold is subtracted from revenues. The lower the cost of goods sold, the higher the gross profit. Consequently, lower cost of goods sold makes an organization look more effective and efficient. A company stating lower cost of goods sold can create the appearance of a more sustainable business model in a competitive market. A company looking to increase the figure of cost of goods sold may under represent the cost of goods sold to impress potential investors. However, this does not provide an accurate presentation of the balance sheet of an entity and, therefore, can bring legal trouble. Sure, a firm can increase its income by attracting more investors, but the investors and other authorities can sue the company if they find out that the cost of goods sold was understated.

# Get Financing

Small businesses often need outside financing to survive and grow in the market. A lower cost of goods sold (COGS) and a more appealing balance sheet may be needed to impress a bank loan officer. Businesses may be tempted to understate their COGS in order to make their business model look more attractive and their profit more sustainable, making them better candidates for loans. A lower COGS makes the financial statements more attractive – at least until it comes time to pay taxes on the earnings. This may impress potential investors and analysts who look only at the documents and do not delve any deeper into the data. The analysis based on provided data – that is, understated cost of goods sold – can provide positive remarks regarding the performance and sustainability of an organization. Therefore, an investor can be convinced to invest their money into the company. Hence, some companies falsely understate the cost of goods sold in order to present their efficiency in the management of cost and achievement of higher profits.

# Considerable Risk

Knowingly filing false financial statements puts a company, the signatory to the documents, and perhaps the business owner in legal jeopardy. State and federal agencies watch for irregularities in balance sheets and are increasingly focusing on the raw data used to compile those numbers. Fraudulently lowering the COGS, or altering anything on financial documents, carries considerable risk of fines, prison terms, or both. Even still, although understating cost of goods sold is illegal and risky, there are companies who do so to attract different stakeholders.

# Legally Minimizing COGS

Companies can value their inventory in a way that legally minimizes the cost of goods sold, depending on the nature of their business. Using the first-in, first out (FIFO) method determines the COGS by using the costs of your oldest inventory first. Depending on what kind of business it is, this may or may not objectively be the optimum strategy. For example, a business that sells rare coins may have won a particular item for \$100 at auction and later spent \$1,000 to acquire another one. If the business then sells that coin for \$900 as part of a promotion, the FIFO method would result in the company showing an \$800 profit, taking the coin that cost \$100 to acquire out of inventory. Using the last-in, first-out inventory value method would record the same transaction as a \$100 loss by removing the \$1,000 coin from inventory.

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## How to Calculate Cost of Goods Sold and Include in Business Tax Return

The cost of goods sold is the calculation of the value of any company’s inventory, which has been sold and the things which have not been sold or will be sold in the future. It is shown similarly on every type of business tax return. On each return, the cost of goods sold is considered a reduction in business income. Therefore, the higher you can legitimately make the cost of the products sold, the less income you will have to pay taxes. The calculation process of the goods sold is the same for all businesses.

## How to Calculate the Cost of Goods Sold

• Gather the information needed for this calculation. Mostly, you will need to know the valuation method, beginning and ending inventory, and the cost of labor and purchases.
• It would help if you were doing the calculation, which starts with beginning inventory, adding in the cost of materials, labor, and other expenses during the end, and then finally calculate the ending inventory.

The calculation of the cost of goods sold depends on tax returns. The cost of products sold is essential for every business as it is an allowable deduction on taxes. If a company fails to add this value, their business income becomes higher than necessary, which means higher taxes.

## Consider the Following Information

• Valuation Method: Designate whether inventory is valued equally to the cost of the market, lower than the cost of the market, or other. If you are using the cash accounting method, make sure that you value inventory at cost. Make sure that your tax preparer is under constant check, especially if you have changed your method of determining quantities, values, or expenses. It would help if you included any changes to make the tax preparer and your employees aware.
• Beginning Inventory: This is the total cost of all products in your inventory at the beginning of any year. Most of the time, this should be the same as the inventory at the end of the year. If it is not the same, you must explain.
• Cost of Purchasing: You should be able to get a total of all the products you purchased during the year and those you placed in the inventory to sell. You should subtract any products that you took out for your personal use. In case you are a manufacturer, you will need to include the total cost of all the raw materials and parts you purchased during that year. It does not matter if they were assembled or not.
• Cost of Labor: This is the cost of your business employees who directly work in making products from raw materials and parts. It does not include expenses for administrators or employees in sales, marketing, finance, or other business areas.
• Costs of Materials and Supplies: These costs should be directly concerning making the product.
• Other Costs: These include your shipping costs, freight-in on materials and the supplies, and the overhead expenses for rent, heat, light, etc. for the area where the products are being manufactured, produced, or assembled.
• Ending Inventory: Calculate and determine the total value of all inventory items at the end of the year.

This is everything that you need to calculate the cost of goods sold using a tax software program or to give to the tax preparer that you have employed. Always make sure that you can provide records verifying the costs of goods sold.

## Summary of How to Calculate the Cost of Goods Sold

• Add up beginning inventory, purchases, and all the other costs.
• Getting costs of the goods sold.
• Subtract the inventory at the end of the year.
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