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Cost of goods sold (COGS) (also cost of products sold (COPS), or cost of sales[1]) is the carrying value of goods sold during a particular period.

Costs are associated with particular goods using one of the several formulas, including specific identification, first-in first-out (FIFO), or average cost. Costs include all costs of purchase, costs of conversion and other costs that are incurred in bringing the inventories to their present location and condition. Costs of goods made by the businesses include material, labor, and allocated overhead.[2] The costs of those goods which are not yet sold are deferred as costs of inventory until the inventory is sold or written down in value.[3]

Overview

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Many businesses sell goods that they have bought or produced. When the goods are bought or produced, the costs associated with such goods are capitalized as part of inventory (or stock) of goods.[4] These costs are treated as an expense in the period the business recognizes income from sale of the goods.[5]

Determining costs requires keeping records of goods or materials purchased and any discounts on such purchase. In addition, if the goods are modified,[6] the business must determine the costs incurred in modifying the goods. Such modification costs include labor, supplies or additional material, supervision, quality control, and use of equipment. Principles for determining costs may be easily stated, but application in practice is often difficult due to a variety of considerations in the allocation of costs.[7]

Cost of goods sold may also reflect adjustments. Among the potential adjustments are decline in value of the goods (i.e., lower market value than cost), obsolescence, damage, etc.

When multiple goods are bought or made, it may be necessary to identify which costs relate to which particular goods sold. This may be done using an identification convention, such as specific identification of the goods, first-in-first-out (FIFO), or average cost. Alternative systems may be used in some countries, such as last-in-first-out (LIFO), gross profit method, retail method, or a combinations of these.

Cost of goods sold may be the same or different for accounting and tax purposes, depending on the rules of the particular jurisdiction. Certain expenses are included in COGS. Expenses that are included in COGS cannot be deducted again as a business expense. COGS expenses include:

  • The cost of products or raw materials, including freight or shipping charges;
  • The direct labor costs of workers who produce the products;
  • The cost of storing products the business sells;
  • Factory overhead expenses.

Importance of inventories

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Inventories have a significant effect on profits.[8] A business that produces or buys goods to sell must keep track of inventories of goods under all accounting and income tax rules. An example illustrates why. Fred buys auto parts and resells them. In 2008, Fred buys $100 worth of parts. He sells parts for $80 that he bought for $30, and has $70 worth of parts left. In 2009, he sells the remainder of the parts for $180. If he keeps track of inventory, his profit in 2008 is $50, and his profit in 2009 is $110, or $160 in total. If he deducted all the costs in 2008, he would have a loss of $20 in 2008 and a profit of $180 in 2009. The total is the same, but the timing is much different. Most countries' accounting and income tax rules (if the country has an income tax) require the use of inventories for all businesses that regularly sell goods they have made or bought.

Cost of goods for resale

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Cost of goods purchased for resale includes purchase price as well as all other costs of acquisitions,[9] excluding any discounts.

Additional costs may include freight paid to acquire the goods, customs duties, sales or use taxes not recoverable paid on materials used, and fees paid for acquisition. For financial reporting purposes such period costs as purchasing department, warehouse, and other operating expenses are usually not treated as part of inventory or cost of goods sold. For U.S. income tax purposes, some of these period costs must be capitalized as part of inventory.[10] Costs of selling, packing, and shipping goods to customers are treated as operating expenses related to the sale. Both International and U.S. accounting standards require that certain abnormal costs, such as those associated with idle capacity, must be treated as expenses rather than part of inventory.

Discounts that must be deducted from the costs of purchased inventory are the following:

  • Trade discounts (reduction in the price of goods that a manufacturer or wholesaler provides to a retailer) – includes a discount that is always allowed, regardless of the time of payment.
  • Manufacturer's rebates – based on the dealer's purchases during the year.
  • Cash discounts (a reduction in the invoice price that the seller provides if the dealer pays immediately or within a specified time) – may reduce COGS, or may be treated separately as gross income.

Value added tax is generally not treated as part of cost of goods sold if it may be used as an input credit or is otherwise recoverable from the taxing authority.[11]

Cost of goods made by the business

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The cost of goods produced in the business should include all costs of production.[12] The key components of cost generally include:

  • Parts, raw materials and supplies used,
  • Labor, including associated costs such as payroll taxes and benefits, and
  • Overhead of the business allocated to production.

Most businesses make more than one of a particular item. Thus, costs are incurred for multiple items rather than a particular item sold. Determining how much of each of these components to allocate to particular goods requires either tracking the particular costs or making some allocations of costs. Parts and raw materials are often tracked to particular sets (e.g., batches or production runs) of goods, then allocated to each item.

Labor costs include direct labor and indirect labor. Direct labor costs are the wages paid to those employees who spend all their time working directly on the product being manufactured. Indirect labor costs are the wages paid to other factory employees involved in production. Costs of payroll taxes and fringe benefits are generally included in labor costs, but may be treated as overhead costs. Labor costs may be allocated to an item or set of items based on timekeeping records.

Costs of materials include direct raw materials, as well as supplies and indirect materials. Where non-incidental amounts of supplies are maintained, the taxpayer must keep inventories of the supplies for income tax purposes, charging them to expense or cost of goods sold as used rather than as purchased.

Materials and labor may be allocated based on past experience, or standard costs. Where materials or labor costs for a period fall short of or exceed the expected amount of standard costs, a variance is recorded. Such variances are then allocated among cost of goods sold and remaining inventory at the end of the period.

Determining overhead costs often involves making assumptions about what costs should be associated with production activities and what costs should be associated with other activities. Traditional cost accounting methods attempt to make these assumptions based on past experience and management judgment as to factual relationships. Activity based costing attempts to allocate costs based on those factors that drive the business to incur the costs.

Overhead costs are often allocated to sets of produced goods based on the ratio of labor hours or costs or the ratio of materials used for producing the set of goods. Overhead costs may be referred to as factory overhead or factory burden for those costs incurred at the plant level or overall burden for those costs incurred at the organization level. Where labor hours are used, a burden rate or overhead cost per hour of labor may be added along with labor costs. Other methods may be used to associate overhead costs with particular goods produced. Overhead rates may be standard rates, in which case there may be variances, or may be adjusted for each set of goods produced.

Identification conventions

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In some cases, the cost of goods sold may be identified with the item sold. Ordinarily, however, the identity of goods is lost between the time of purchase or manufacture and the time of sale.[13] Determining which goods have been sold, and the cost of those goods, requires either identifying the goods or using a convention to assume which goods were sold. This may be referred to as a cost flow assumption or inventory identification assumption or convention.[14] The following methods are available in many jurisdictions for associating costs with goods sold and goods still on hand:

  • Specific identification. Under this method, particular items are identified, and costs are tracked with respect to each item.[15] This may require considerable recordkeeping. This method cannot be used where the goods or items are indistinguishable or fungible.
  • Average cost. The average cost method relies on average unit cost to calculate cost of units sold and ending inventory. Several variations on the calculation may be used, including weighted average and moving average.
  • First-In First-Out (FIFO) assumes that the items purchased or produced first are sold first. Costs of inventory per unit or item are determined at the time produces or purchased. The oldest cost (i.e., the first in) is then matched against revenue and assigned to cost of goods sold.
  • Last-In First-Out (LIFO) is the reverse of FIFO. Some systems permit determining the costs of goods at the time acquired or made, but assigning costs to goods sold under the assumption that the goods made or acquired last are sold first. Costs of specific goods acquired or made are added to a pool of costs for the type of goods. Under this system, the business may maintain costs under FIFO but track an offset in the form of a LIFO reserve. Such reserve (an asset or contra-asset) represents the difference in cost of inventory under the FIFO and LIFO assumptions. Such amount may be different for financial reporting and tax purposes in the United States.
  • Dollar Value LIFO. Under this variation of LIFO, increases or decreases in the LIFO reserve are determined based on dollar values rather than quantities.
  • Retail inventory method. Resellers of goods may use this method to simplify record keeping. The calculated cost of goods on hand at the end of a period is the ratio of cost of goods acquired to the retail value of the goods times the retail value of goods on hand. Cost of goods acquired includes beginning inventory as previously valued plus purchases. Cost of goods sold is then beginning inventory plus purchases less the calculated cost of goods on hand at the end of the period.

Example

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Jane owns a business that resells machines. At the start of 2009, she has no machines or parts on hand. She buys machines A and B for 10 each, and later buys machines C and D for 12 each. All the machines are the same, but they have serial numbers. Jane sells machines A and C for 20 each. Her cost of goods sold depends on her inventory method. Under specific identification, the cost of goods sold is 10 + 12, the particular costs of machines A and C. If she uses FIFO, her costs are 20 (10+10). If she uses average cost, her costs are 22 ( (10+10+12+12)/4 x 2). If she uses LIFO, her costs are 24 (12+12). Thus, her profit for accounting and tax purposes may be 20, 18, or 16, depending on her inventory method. After the sales, her inventory values are either 20, 22 or 24.

After year end, Jane decides she can make more money by improving machines B and D. She buys and uses 10 of parts and supplies, and it takes 6 hours at 2 per hour to make the improvements to each machine. Jane has overhead, including rent and electricity. She calculates that the overhead adds 0.5 per hour to her costs. Thus, Jane has spent 20 to improve each machine (10/2 + 12 + (6 x 0.5) ). She sells machine D for 45. Her cost for that machine depends on her inventory method. If she used FIFO, the cost of machine D is 12 plus 20 she spent improving it, for a profit of 13. Remember, she used up the two 10 cost items already under FIFO. If she uses average cost, it is 11 plus 20, for a profit of 14. If she used LIFO, the cost would be 10 plus 20 for a profit of 15.

In year 3, Jane sells the last machine for 38 and quits the business. She recovers the last of her costs. Her total profits for the three years are the same under all inventory methods. Only the timing of income and the balance of inventory differ. Here is a comparison under FIFO, Average Cost, and LIFO:

Cost of Goods Sold Profit
Year Sales FIFO Avg. LIFO FIFO Avg. LIFO
1 40 20 22 24 20 18 16
2 45 32 31 30 13 14 15
3 38 32 31 30 6 7 8
Total 123 84 84 84 39 39 39

Write-downs and allowances

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The value of goods held for sale by a business may decline due to a number of factors. The goods may prove to be defective or below normal quality standards (subnormal). The goods may become obsolete. The market value of the goods may simply decline due to economic factors.

Where the market value of goods has declined for whatever reasons, the business may choose to value its inventory at the lower of cost or market value, also known as net realizable value.[16] This may be recorded by accruing an expense (i.e., creating an inventory reserve) for declines due to obsolescence, etc. Current period net income as well as net inventory value at the end of the period is reduced for the decline in value.

Any property held by a business may decline in value or be damaged by unusual events, such as a fire. The loss of value where the goods are destroyed is accounted for as a loss, and the inventory is fully written off. Generally, such loss is recognized for both financial reporting and tax purposes. However, book and tax amounts may differ under some systems.

Alternative views

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Alternatives to traditional cost accounting have been proposed by various management theorists. These include:

  • Throughput accounting, under the Theory of Constraints, under which only totally variable costs are included in cost of goods sold and inventory is treated as investment.
  • Lean accounting, in which most traditional costing methods are ignored in favor of measuring weekly "value streams".
  • Resource consumption accounting, which discards most current accounting concepts in favor of proportional costing based on simulations.

None of these views conform to U.S. Generally Accepted Accounting Principles or International Accounting Standards, nor are any accepted for most income or other tax reporting purposes.

Other terms

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Net sales = gross sales – (customer discounts, returns, and allowances)
Gross profit = net sales – cost of goods sold
Operating profit = gross profit – total operating expenses
Net profit = operating profit – taxes – interest
Net profit = net sales – cost of goods sold – operating expense – taxes – interest

See also

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References

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Further reading

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Revisions and contributorsEdit on WikipediaRead on Wikipedia

Cost of goods sold

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Cost of goods sold (COGS) is the direct cost incurred by a to or acquire the it sells during a reporting period, encompassing expenses such as raw materials, direct labor, and allocable overhead directly tied to production. This metric is essential for determining gross profit, as it is subtracted from on the to reflect the profitability of core operations before other expenses. Under U.S. Generally Accepted Principles (), COGS is derived from accounting principles outlined in ASC Topic 330, where is valued at the lower of or net realizable value (NRV), with NRV defined as the estimated selling price less costs of completion, disposal, and transportation. The standard formula for calculating COGS is beginning plus purchases (and other production ) minus ending , ensuring costs are matched to the period's via methods like FIFO, LIFO (though LIFO is not permitted under IFRS), or weighted average . For tax purposes, the requires similar computation on forms like Schedule C for sole proprietors or Form 1125-A for corporations, but small businesses with average annual gross receipts of $31 million or less over the prior three years (for taxable years beginning in 2025) may elect to treat as non-incidental supplies and avoid formal COGS reporting. COGS excludes indirect costs such as selling, general, and administrative expenses, focusing solely on production-related outlays to provide insight into and pricing strategies. Accurate COGS tracking is critical for , financial reporting, and compliance, as miscalculations can distort gross margins and lead to adjustments or issues. Variations in valuation methods can significantly impact reported figures, particularly in inflationary environments, influencing decisions on sourcing, production scaling, and profitability .

Definition and Fundamentals

Overview

Cost of goods sold (COGS) represents the attributable to the production of sold by a or the acquisition of for resale during a specific period. This metric is essential in as it enables businesses to determine gross profit by deducting these costs from , providing insight into the profitability of core operations. Under both U.S. Generally Accepted Principles (GAAP) and International Financial Reporting Standards (IFRS), COGS ensures that expenses are matched to the revenues they generate, adhering to the basis of . For businesses that produce goods, the core components of COGS include direct materials, which are the raw materials directly incorporated into the final product; direct labor, encompassing wages for workers directly involved in production; and manufacturing overhead, such as utilities and on factory equipment allocated to production. In contrast, for companies engaged in resale without , COGS primarily consists of the purchase costs of the goods acquired for sale, including freight-in but excluding selling expenses. The foundations of modern accounting practices, including those used to calculate COGS, trace back to the development of double-entry bookkeeping in the 15th century, as described by Italian mathematician Luca Pacioli in his 1494 treatise Summa de arithmetica, geometria, proportioni et proportionalita, which introduced systematic tracking of assets such as inventory. It was later formalized in modern accounting standards, with GAAP outlined in ASC 330 and IFRS in IAS 2, emphasizing cost measurement for inventories that flow into COGS. At a high level, COGS is computed as beginning inventory plus purchases (or production costs) minus ending inventory, capturing the cost of goods that transitioned from stock to sales during the period.

Role in Financial Statements

In the income statement, cost of goods sold (COGS) is typically presented as the first expense deducted from net revenue, immediately after sales or revenue figures, to determine gross profit. This placement highlights COGS as a direct cost associated with producing or acquiring the goods sold during the period, providing an initial measure of a company's core operational profitability under U.S. Generally Accepted Principles (). A primary metric derived from COGS is the , calculated as ( minus COGS) divided by , expressed as a , which assesses the of production and pricing strategies by indicating the proportion of retained after covering . This ratio is crucial for evaluating , as a higher suggests better cost control or pricing power, while declines may signal rising input costs or competitive pressures. COGS connects to the balance sheet through its impact on , a ; as goods are sold, the corresponding costs are transferred from to COGS on the , reducing the reported value and thereby affecting current assets and (current assets minus current liabilities). This linkage influences ratios, such as the , by reflecting how efficiently is managed to support liquidity without tying up excessive resources. In financial analysis, COGS plays a central role in ratio analysis, notably the inventory turnover ratio—computed as COGS divided by average —which measures how quickly a sells and replenishes stock, with higher values indicating efficient inventory management and lower holding costs. Analysts also use COGS trends over multiple periods to evaluate profitability sustainability, cost fluctuations, and overall business health, often comparing against industry benchmarks to identify operational improvements or risks.

Calculation Approaches

For Retail and Resale Businesses

In retail and resale businesses, where goods are purchased from suppliers and sold without significant alteration, the cost of goods sold (COGS) represents the associated with acquiring those goods for resale. The standard for calculating COGS in this context is: COGS = Beginning + Net Purchases + Freight-In - Ending . This approach focuses on the flow of costs during the accounting period, ensuring that only the cost of goods actually sold is recognized as an expense. Net purchases are determined by subtracting purchase returns, allowances, and discounts from gross purchases, reflecting the actual cost incurred after adjustments for defective or returned items and negotiated reductions. Freight-in, which includes transportation costs to bring to the retailer's location, is added to the cost of as it directly contributes to the acquisition . Handling fees, such as or costs during transit, are also included if they are integral to obtaining of the . However, selling expenses like outbound shipping to customers or costs are excluded from COGS, as they are classified as operating expenses rather than acquisition costs. The calculation of COGS in retail settings varies depending on whether a perpetual or periodic is used. In a perpetual , inventory records are updated continuously with each purchase and sale, allowing COGS to be tracked in real-time by debiting COGS and crediting at the point of sale. This method provides immediate visibility into levels and costs, which is particularly useful for retailers with high transaction volumes. Conversely, a periodic updates records only at the end of the accounting period through physical counts, with COGS calculated retrospectively using the above to determine the cost of goods available for sale minus ending . Periodic systems are simpler and less costly to implement for smaller resale operations but may lead to less precise tracking during the period. Retail businesses often encounter specific considerations in COGS calculation related to bulk purchases, vendor allowances, and trade discounts. Bulk purchases, common in resale to achieve economies of scale, are recorded at their net cost after any volume-based reductions, ensuring the inventory value reflects the actual expenditure. Vendor allowances, such as promotional rebates or reimbursements for cooperative advertising, are typically treated as reductions in the cost of purchases, thereby lowering the overall COGS when received. Trade discounts, offered by suppliers for prompt payment or large orders, are deducted from the invoice price to arrive at the net purchase amount before inclusion in the COGS formula, preventing overstatement of acquisition costs. These adjustments promote accurate cost matching with revenues in resale operations.

For Manufacturing Businesses

For manufacturing businesses, the cost of goods sold (COGS) accounts for the transformation of raw materials into finished products through production processes, incorporating direct and incurred during . Unlike retail operations that focus solely on purchase costs, manufacturing COGS emphasizes production expenses to reflect the true cost of goods completed and sold. The fundamental formula for calculating COGS in this sector is: COGS=Beginning Finished Goods Inventory+Cost of Goods Manufactured−Ending Finished Goods Inventory\text{COGS} = \text{Beginning Finished Goods Inventory} + \text{Cost of Goods Manufactured} - \text{Ending Finished Goods Inventory} This approach ensures that only the cost of goods available for sale and subsequently sold is recognized as an expense in the period. The Cost of Goods Manufactured (COGM) serves as a key input to the COGS , representing the total production costs transferred from work-in-process to inventory during the accounting period. COGM is derived from the formula: COGM=Beginning Work-in-Process Inventory+Total Manufacturing Costs−Ending Work-in-Process Inventory\text{COGM} = \text{Beginning Work-in-Process Inventory} + \text{Total Manufacturing Costs} - \text{Ending Work-in-Process Inventory} where Total Manufacturing Costs break down into three primary components: direct materials used in production, direct labor costs for workers directly involved in assembly or fabrication, and applied manufacturing overhead for indirect production expenses such as factory utilities, depreciation on equipment, and supervisory salaries. Direct materials are typically calculated as beginning raw materials inventory plus purchases minus ending raw materials inventory, reflecting the flow of resources requisitioned from storage into the production process. Direct labor includes wages, benefits, and payroll taxes for employees engaged in transforming materials, often tracked via time sheets or labor hours. Manufacturing overhead allocation is a critical aspect of COGM under U.S. (ASC 330), requiring full absorption costing to assign both variable and fixed overhead to units produced based on normal production capacity. Predetermined overhead rates are commonly used to apply these costs, calculated in advance as estimated total overhead divided by an allocation base such as direct labor hours or hours, and then adjusted periodically to align with actual expenditures. For instance, if a estimates $500,000 in annual overhead and anticipates 100,000 hours, the rate would be $5 per hour, applied to products as they move through production. This method ensures overhead is systematically distributed to rather than expensed immediately. In contrast, variable costing allocates only variable overhead to products while treating fixed overhead as a period cost, a distinction relevant for internal decision-making but not permissible under GAAP for external financial reporting, where absorption costing is mandatory to match costs with revenues. The integration of inventories in manufacturing COGS highlights the sequential flow from raw materials to finished goods. Raw materials inventory accumulates costs upon purchase and is transferred to work-in-process (WIP) inventory as materials are issued for production, where direct labor and overhead are added until goods are completed. Upon completion, costs move to inventory, remaining there until sales occur, at which point they contribute to COGS via the formula outlined above. This inventory progression ensures accurate cost matching, with WIP serving as an to capture partially completed items and prevent under- or overstatement of production expenses. Effective management of these inventory layers is essential for precise COGS determination and financial reporting compliance.

Inventory Management Techniques

Identification and Valuation Methods

Identification and valuation methods for inventory are essential in determining the cost of goods sold (COGS), as they assign costs to inventory units based on cost flow assumptions rather than physical movement. Under accounting standards, businesses select from several permissible methods to value inventory, ensuring consistency and relevance in financial reporting. These methods include First-In, First-Out (FIFO), Last-In, First-Out (LIFO), Weighted Average Cost, and Specific Identification, each with distinct mechanics and implications for COGS calculation. The FIFO method assumes that the oldest costs are the first to be sold, leaving the most recent costs in ending . This approach aligns with the physical flow of in many operations, such as perishable items, and during periods of , it results in lower COGS and higher reported profits because older, cheaper costs are matched against current revenues. However, FIFO can lead to valuation that does not reflect current replacement costs, potentially overstating asset values on sheet in inflationary environments. In contrast, the LIFO method presumes that the newest, most recent costs are sold first, assigning older costs to remaining . This is advantageous in rising price scenarios, as it increases COGS by using higher recent costs, thereby reducing and liabilities while better matching current costs with revenues for improved . A key restriction under U.S. is the LIFO conformity rule, which mandates that if LIFO is used for financial reporting, it must also be applied for tax purposes to prevent selective use for tax benefits alone. Despite these benefits, LIFO can undervalue on the balance sheet during , raising concerns about representational faithfulness. The Weighted Average Cost method calculates an average cost per unit by dividing the of available for sale by the available, smoothing out fluctuations across the pool. This approach is simpler for businesses with homogeneous products and minimizes the volatility in COGS seen in FIFO or LIFO, providing a balanced representation of costs without assuming a specific flow order. It is particularly useful when individual tracking is impractical, though it may dilute the impact of recent changes. Specific Identification tracks the actual of each individual item sold, ideal for high-value, unique like automobiles or jewelry where precise costing is feasible. This method offers the highest accuracy by avoiding assumptions about cost flows, directly linking to purchase costs for transparent reporting. However, it requires sophisticated record-keeping and is less practical for large volumes of interchangeable items due to administrative complexity. Internationally, under IFRS, LIFO is prohibited, with FIFO, Weighted Average, and Specific Identification permitted to ensure inventory is valued at the lower of cost or net realizable value, emphasizing relevance to current economic conditions. IFRS also allows fair value measurement for certain inventories, such as those held by commodity brokers, diverging from U.S. GAAP's allowance of LIFO and market value assessments. These variations promote global comparability while adapting to local regulatory needs.

Adjustments for Impairments

Adjustments for impairments involve reducing the carrying value of when its recoverable amount falls below , typically due to , , or market declines, with the resulting loss recognized as an expense that increases the cost of goods sold (COGS). These adjustments ensure that is not overstated on the balance sheet and that COGS reflects realistic , aligning with the principle in . Under International Financial Reporting Standards (IFRS), specifically IAS 2, inventories are measured at the lower of cost and net realizable value (NRV), requiring write-downs to NRV when the latter is lower. In contrast, under U.S. Generally Accepted Accounting Principles (GAAP), as updated by FASB's Accounting Standards Update (ASU) 2015-11 in ASC 330, most inventories (excluding those using LIFO or retail methods) are valued at the lower of cost or NRV, replacing the prior lower of cost or market (LCM) rule, though LCM remains applicable for LIFO and retail inventories. The NRV calculation, common to both frameworks for applicable inventories, is determined as follows: NRV=Estimated selling price in the ordinary course of business−Estimated costs of completion and disposal\text{NRV} = \text{Estimated selling price in the ordinary course of business} - \text{Estimated costs of completion and disposal} If the NRV falls below the inventory's carrying amount, an impairment loss is recognized immediately in profit or loss, typically as part of COGS, to match the expense with the period's revenues. For example, if inventory originally cost $100 but its NRV drops to $80 due to , a $20 write-down increases COGS by that amount. Companies often establish allowances or reserves to estimate and account for expected inventory losses from shrinkage (e.g., theft or loss), spoilage (e.g., perishable goods deterioration), or returns (e.g., defective products). These contra-asset accounts reduce the 's net carrying value without immediately writing off specific items, providing a systematic approach to impairments; abnormal spoilage, however, is expensed directly rather than capitalized in inventory costs. Reversal policies differ between frameworks: under IFRS (IAS 2), if the NRV subsequently increases due to changed circumstances, the impairment loss can be reversed up to the original cost, with the gain recognized in profit or loss (reducing COGS if applicable). U.S. GAAP, however, prohibits reversals of inventory write-downs, treating the new lower value as the cost basis for future periods. Tax implications vary by jurisdiction, affecting the deductibility of write-downs and reserves. , under IRS rules, inventory write-downs to NRV (or market for LIFO) are deductible as part of COGS when they reflect actual economic losses, provided they conform to the taxpayer's accounting method and are not merely reserves without basis. In jurisdictions following IFRS, such as many countries, write-downs and reversals are generally deductible if they align with computations, though some (e.g., ) impose restrictions on reserves to prevent income manipulation. In contrast, countries like allow deductions for inventory reserves only if supported by specific evidence of impairment, emphasizing verifiable losses over estimates.

Practical Applications and Variations

Illustrative Examples

To illustrate the calculation of cost of goods sold (COGS) for a retail business focused on resale, the standard formula is beginning inventory plus purchases minus ending inventory. This yields the direct cost of goods sold during the period, excluding operating expenses. For a manufacturing business, COGS involves aggregating direct materials, direct labor, and manufacturing overhead into the cost of goods manufactured (COGM), then adjusting for changes in finished goods inventory. Beginning finished goods plus COGM minus ending finished goods determines the COGS, ensuring only the cost of completed goods sold is recognized in the period. The choice of inventory valuation method, such as first-in, first-out (FIFO) or last-in, first-out (LIFO), can significantly affect COGS, particularly in periods of rising prices. For example, assume beginning of 100 units at $10 each ($1,000 total), purchases of 200 units at $15 each ($3,000), and sales of 250 units, leaving 50 units in ending . Under FIFO, COGS would be (100 × $10) + (150 × $15) = $1,000 + $2,250 = $3,250, with ending at 50 × $15 = $750. Under LIFO, COGS would be (200 × $15) + (50 × $10) = $3,000 + $500 = $3,500, with ending at 50 × $10 = $500. Under rising prices, FIFO produces a lower COGS and higher reported gross profit compared to LIFO. Inventory adjustments for impairments, such as obsolescence, are added directly to COGS to reflect reduced realizable value. For example, if a business identifies obsolete inventory due to technological changes rendering items unsellable, it records a write-down by debiting COGS and crediting the inventory account. This increases the total COGS for the period, ensuring financial statements accurately portray the economic cost of goods available for sale.

Alternative Perspectives and Terms

In accounting, two primary costing methods influence how cost of goods sold (COGS) is determined: absorption costing and variable costing. Absorption costing, required under GAAP and IFRS for external financial reporting, allocates both variable and fixed manufacturing overhead to products, thereby including these costs in COGS to reflect the full cost of production. In contrast, variable costing treats only direct materials, direct labor, and variable overhead as product costs included in COGS, while fixed overhead is expensed as a period cost; this approach is favored for internal decision-making, such as pricing, profitability analysis, and break-even calculations, as it provides clearer insights into contribution margins without the distortions from fixed cost deferrals in inventory. The choice between these methods can significantly affect reported profitability, with absorption costing potentially deferring fixed costs to future periods through inventory buildup, whereas variable costing highlights immediate operational efficiency. Industry variations adapt the COGS concept to non-traditional manufacturing contexts. In service businesses, which lack physical inventory, the equivalent metric is often termed "cost of services," encompassing direct labor, subcontractor fees, and materials used in service delivery, such as consultant salaries and expenses in a professional firm; this allows for similar analysis without qualifying for traditional COGS deductions under IRS rules. For e-commerce operations, COGS has evolved to include fulfillment costs like , inbound shipping from suppliers, and outbound delivery fees, particularly as retail expanded post-2020 amid pandemic-driven growth; under GAAP and IFRS, these direct costs are incorporated when trackable per unit to accurately match expenses with upon shipment. In hardware operations, such as data centers providing cloud or hosting services, COGS includes direct costs related to service delivery, notably power and electricity usage, which often represents the largest expense for running servers, storage, and networking equipment; bandwidth and network connectivity costs for internet, redundant connections, and data transfer; and allocated depreciation of hardware assets attributable to the provision of services. These costs are recognized under GAAP and IFRS as they directly relate to the generation of revenue from digital services, enabling accurate gross profit measurement in technology-intensive sectors. Related terms broaden or narrow the COGS framework. "Cost of sales" serves as a in some contexts but may encompass in service or retail sectors; it excludes indirect selling expenses like commissions or distribution costs, which are classified as operating expenses. "Prime cost," a of COGS, specifically refers to the sum of direct materials and direct labor, excluding overhead, and is used in cost analysis to isolate core production inputs for efficiency evaluations. Emerging perspectives incorporate into cost analysis under ESG reporting frameworks, with companies using internal carbon pricing to account for emissions-related expenses in supply chains, such as carbon taxes or shadow pricing, for ; as of 2025, these practices aid compliance with standards like the EU's Reporting Directive but remain non-mandatory for integration into COGS under GAAP/IFRS, focusing instead on disclosure in sustainability reports. For small businesses, the IRS allows those with average annual gross receipts of $30 million or less (as of 2025, subject to adjustments) to treat as non-incidental supplies and avoid formal COGS reporting.

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