Cost of goods sold journal entry
/What is the Cost of Goods Sold?
The cost goods sold is the cost assigned to those goods or services that correspond to sales made to customers. In the case of merchandise, this usually means goods that were physically shipped to customers, but it can also mean goods that are still on a company's premises under bill and hold arrangements with customers. In either case, the accountant needs to reduce ending inventory by the amount of those goods that either were shipped to customers or designated as being customer-owned under a bill and hold arrangement.
How to Create a Cost of Goods Sold Journal Entry
Follow these steps to arrive at the cost of goods sold journal entry:
Verify the beginning inventory balance. The actual amount of beginning inventory owned by the company is properly valued and reflects the balances in the various inventory asset accounts in the general ledger. If there is a difference between the beginning balance in the general ledger and the actual cost of the beginning inventory, the difference will flush out through the cost of goods sold in the current accounting period.
Accumulate purchased inventory costs. As the accounting period progresses and the business receives invoices from suppliers for inventory items shipped to the company, record them either in a single purchases account or in whichever inventory asset account is most applicable. Be sure to accrue purchases at the end of the accounting period if goods have been received but not the related supplier invoice.
Accumulate and allocate overhead costs. Any other costs involved in bringing sellable inventory to the location and condition needed to sell it are designated as overhead, and allocated to all items produced during the accounting period.
Determine ending inventory units. Either conduct a physical inventory count at the end of the period to determine the exact quantities of items on hand, or use a perpetual inventory system to derive these balances (which typically involves the use of cycle counting).
Determine cost of ending inventory. This can be a complicated process, since the accountant may use a variety of cost layering systems, such as FIFO, LIFO, or the weighted average method to determine cost. The costing calculation will vary, depending on the costing system being used.
Determine the cost of goods sold. If a purchases account is being used, add the balance in that account to the beginning inventory total and then subtract the costed ending inventory total to arrive at the cost of goods sold. If the firm is instead using several inventory accounts instead of a purchases account, then add them together and subtract the costed ending inventory total to arrive at the cost of goods sold.
Generate cost of goods sold entry. If a purchases account is being used, then the cost of goods sold journal entry should reduce that account balance to zero, as well as adjust the inventory account balance to match the costed ending inventory total.
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Example of a Cost of Goods Sold Journal Entry
Simple version: ABC International has a beginning balance in its inventory asset account of $500,000. It buys $450,000 of materials from suppliers during the month. At month-end, it counts its ending inventory and determines that there is $200,000 of inventory on hand. The cost of goods sold journal entry is:
| Debit | Credit | |
| Cost of goods sold expense | 750,000 | |
| Purchases |
450,000 | |
| Inventory | 300,000 |
This entry matches the ending balance in the inventory account to the costed actual ending inventory, while eliminating the $450,000 balance in the purchases account.
Advanced version: ABC International has a beginning balance in its inventory asset account of $1,000,000. It buys $350,000 of materials from suppliers during the month, which it records in the inventory account. At month-end, it counts its ending inventory and determines that there is $475,000 of inventory on hand. In addition, ABC incurs $150,000 of overhead costs, which it records in an overhead cost pool asset account. There are now two cost of goods sold journal entries, of which the first is:
| Debit | Credit | |
| Cost of goods sold expense | 875,000 | |
| Purchases |
350,000 | |
| Inventory | 525,000 |
The first entry was similar to the transaction noted earlier in the simple version, where we eliminated the balance in the purchases account and altered the ending inventory balance to match the costed amount of ending inventory.
In addition, there is $150,000 of overhead to allocate to the items produced during the month. An analysis of produced items reveals that 1/3 were sold and 2/3 retained in inventory. Thus, the cost allocation is:
| Debit | Credit | |
| Inventory | 100,000 | |
| Cost of goods sold | 50,000 | |
| Overhead cost pool | 150,000 |
Why is the Cost of Goods Sold Important?
There are several reasons why it is essential to derive a correct cost of goods sold figure. First, this may be the largest expense reported by a business, so it has the greatest impact on whether you can report a profit. Second, it is used to derive the gross profit percentage (which is net sales - cost of goods sold, divided by net sales). The gross profit percentage is closely watched by management and investors, since it is a strong indicator of whether your pricing policies and cost management are yielding a reasonable gross margin. Of particular concern is when there is a declining trend in the gross profit margin. Therefore, it is essential to correctly calculate the cost of goods sold in every reporting period.
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