January 18, 2009
Cost of Goods Sold (COGS) accounts are very similar to the more common expense accounts as they both represent money outflows or promises of cash. They differ, however, in their accounting relationship to the revenue accounts and their placement on the profit and loss report. The profit and loss report begins with the revenue section, followed immediately by the cost of goods sold. The cost of goods sold are subtracted from revenue and result in a gross profit i.e., the profit relating directly to the delivery of your product or service. Operating expenses are then subtracted from the gross profit to arrive at net profit or loss for the time period being reported.
The accounting relationship that the cost of goods sold accounts have with the revenue accounts can best be illustrated by asking yourself these questions: Would you need to pay for this item whether or not a sale had occurred? Is it directly related to the production of inventory or the delivery of service? For example, your utility bills and rent would typically still need to be paid whether or not you had any sales. Cost of goods sold items, on the other hand, include purchases for resale like wood, automotive parts, food ingredients, etc., and would not have to be purchased unless there was a sale. In practice, these items will normally be recorded on the balance sheet as inventory until ultimately sold to a customer, at which time the inventory is recorded as cost of goods sold.
In most cases, asking yourself the questions above will help you in determining whether an item is an operating expense or a cost of goods sold. When questions arise about how to account for ancillary products and services, it is recommended that you consult with an Accounting Firm who can help you with these determinations.