Cost Of Goods Sold (COGS) / Harga Pokok Penjualan (HPP)

Cost of goods sold (COGS) refer to the inventory costs of those goods a business has sold during a particular period. Costs are associated with particular goods using one of 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 incurred in bringing the inventories to their present location and condition. Costs of goods made by the business include material, labor, and allocated overhead. The costs of those goods not yet sold are deferred as costs of inventory until the inventory is sold or written down in value.

Cost of Goods Sold (COGS), also known as cost of sales, is the total direct expenses incurred in the production of a good, including the cost of materials used to make that good and the cost of labor to produce it. It does not include indirect expenses, like marketing, accounting, and shipping. It’s important for a business to know the COGS of its products, since this helps it determine accurately which products is turning a profit. By subtracting the COGS from the sales revenue, a business can determine the gross profit earned on particular goods. Net profit, in the same way, is the difference between COGS and indirect expenses from sales revenue.

The way these costs relate to profit can be seen in the following example. James owns a business that resells machines. At the start of 2009, he has no machines or parts on hand. He 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. James sells machines A and C for 20 each. His 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 he uses FIFO, his costs are 20 (10+10). If he uses average cost, his costs are 22 ( (10+10+12+12)/4 x 2). If he uses LIFO, his costs are 24 (12+12). Thus, his profit for accounting and tax purposes may be 20, 18, or 16, depending on his inventory method. After the sales, his inventory values are either 20, 22 or 24.

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

In year 3, James sells the last machine for 38 and quits the business. He recovers the last of her costs. His 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:

Transaction No. year of Machine Name Cost Profit
1 1 A -10 -10
2 1 B -10 -10
3 1 C -12 -12
4 1 D -12 -12
5 1 A 20 10
6 1 C 20 8
7 2 B -20 -30
8 2 D -20 -32
9 2 D 45 13
10 3 B 38 8
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

Cost Flow Assumptions/Inventory Identification Conventions

The following methods are available in many jurisdictions for associating costs with goods sold and goods still on hand:

  • 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 made or acquired. 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.

Each of the three cost flow assumptions listed above can be used in either of two systems (or methods) of inventory:

A.   Periodic
B.   Perpetual

A.  Periodic inventory system. Under this system the amount appearing in the Inventory account is not updated when purchases of merchandise are made from suppliers. Rather, the Inventory account is commonly updated or adjusted only once—at the end of the year. During the year the Inventory account will likely show only the cost of inventory at the end of the previous year.

Under the periodic inventory system, purchases of merchandise are recorded in one or more Purchases accounts. At the end of the year the Purchases account(s) are closed and the Inventory account is adjusted to equal the cost of the merchandise actually on hand at the end of the year. Under the periodic system there is no Cost of Goods Sold account to be updated when a sale of merchandise occurs.

In short, under the periodic inventory system there is no way to tell from the general ledger accounts the amount of inventory or the cost of goods sold.

B.  Perpetual inventory system. Under this system the Inventory account is continuously updated. The Inventory account is increased with the cost of merchandise purchased from suppliers and it is reduced by the cost of merchandise that has been sold to customers. (The Purchases account(s) do not exist.)

Under the perpetual system there is a Cost of Goods Sold account that is debited at the time of each sale for the cost of the merchandise that was sold. Under the perpetual system a sale of merchandise will result in two journal entries: one to record the sale and the cash or accounts receivable, and one to reduce inventory and to increase cost of goods sold.

The combination of the three cost flow assumptions and the two inventory systems results in six available options when accounting for the cost of inventory and calculating the cost of goods sold:

A1.   Periodic FIFO
A2.   Periodic LIFO
A3.   Periodic Average

B1.   Perpetual FIFO
B2.   Perpetual LIFO
B3.   Perpetual Average

A1. Periodic FIFO

“Periodic” means that the Inventory account is not routinely updated during the accounting period. Instead, the cost of merchandise purchased from suppliers is debited to an account called Purchases. At the end of the accounting year the Inventory account is adjusted to equal the cost of the merchandise that has not been sold. The cost of goods sold that will be reported on the income statement will be computed by taking the cost of the goods purchased and subtracting the increase in inventory (or adding the decrease in inventory).

“FIFO” is an acronym for First In, First Out. Under the FIFO cost flow assumption, the first (oldest) costs are the first ones to leave inventory and become the cost of goods sold on the income statement. The last (or recent) costs will be reported as inventory on the balance sheet.

Let’s illustrate periodic FIFO with the amounts from the Bookstore:

Number of Books Cost per Book Total Cost
Inventory at Dec. 31, 2010 1 @ $ 85 = $  85
First purchase (January 2011) 1 @ 87 = 87
Second purchase (June 2011) 2 @ 89 = 178
Third purchase (December 2011) 1 @ 90 =     90
Total goods available for sale 5 $440
Less: Inventory at Dec. 31, 2011 4 – 355
Cost of goods sold 1 @ $85 $  85

As before, we need to account for the total goods available for sale (5 books at a cost of $440). Under FIFO we assign the first cost of $85 to the one book that was sold. The remaining $355 ($440 – $85) is assigned to inventory. The $355 of inventory costs consists of $87 + $89 + $89 + $90. The $85 cost assigned to the book sold is permanently gone from inventory.

If the Bookstore sells the textbook for $110, its gross profit under periodic FIFO will be $25 ($110 – $85). If the costs of textbooks continue to increase, FIFO will always result in more profit than other cost flows, because the first cost is always lower.

A2. Periodic LIFO

“Periodic” means that the Inventory account is not updated during the accounting period. Instead, the cost of merchandise purchased from suppliers is debited to an account called Purchases. At the end of the accounting year the Inventory account is adjusted to equal the cost of the merchandise that is unsold. The other costs of goods will be reported on the income statement as the cost of goods sold.

“LIFO” is an acronym for Last In, First Out. Under the LIFO cost flow assumption, the last (or recent) costs are the first ones to leave inventory and become the cost of goods sold on the income statement. The first (or oldest) costs will be reported as inventory on the balance sheet.

It’s important to note that under LIFO periodic (not LIFO perpetual) we wait until the entire year is over before assigning the costs. Then we flow the year’s last costs first, even if those goods arrived after the last sale of the year. For example, assume the last sale of the year at the Bookstore occurred on December 27. Also assume that the store’s last purchase of the year arrived on December 31. Under LIFO periodic, the cost of the book purchased on December 31 is sent to the cost of goods sold first, even though it’s physically impossible for that book to be the one sold on December 27. (This reinforces our previous statement that the flow of costs does not have to correspond with the physical flow of units.)

Let’s illustrate periodic LIFO by using the data for the Bookstore:

Number of Books Cost per Book Total Cost
Inventory at Dec. 31, 2009 1 @ $85 = $  85
First purchase (January 2010) 1 @ 87 = 87
Second purchase (June 2010) 2 @ 89 = 178
Third purchase (December 2010) 1 @ 90 =     90
Total goods available for sale 5 $440
Less: Inventory at Dec. 31, 2010 4 – 350
Cost of goods sold 1 @ $90 $  90

As before we need to account for the total goods available for sale: 5 books at a cost of $440. Under periodic LIFO we assign the last cost of $90 to the one book that was sold. (If two books were sold, $90 would be assigned to the first book and $89 to the second book.) The remaining $350 ($440 – $90) is assigned to inventory. The $350 of inventory cost consists of $85 + $87 + $89 + $89. The $90 assigned to the book that was sold is permanently gone from inventory.

If the bookstore sold the textbook for $110, its gross profit under periodic LIFO will be $20 ($110 – $90). If the costs of textbooks continue to increase, LIFO will always result in the least amount of profit. (The reason is that the last costs will always be higher than the first costs. Higher costs result in less profits and usually lower income taxes.)

A3. Periodic Average

Under “periodic” the Inventory account is not updated and purchases of merchandise are recorded in an account called Purchases. Under this cost flow assumption an average cost is calculated using the total goods available for sale (cost from the beginning inventory plus the costs of all subsequent purchases made during the entire year). In other words, the periodic average cost is calculated after the year is over—after all the puchases of the year have occurred. This average cost is then applied to the units sold during the year as well as to the units in inventory at the end of the year.

As you can see, our facts remain the same—there are 5 books available for sale for the year 2010 and the cost of the goods available is $440. The weighted average cost of the books is $88 ($440 of cost of goods available ÷ 5 books available) and it is used for both the cost of goods sold and for the cost of the books in inventory.

Number of Books Cost per Book Total Cost
Inventory at Dec. 31, 2009 1 @ $85 = $  85
First purchase (January 2010) 1 @ 87 = 87
Second purchase (June 2010) 2 @ 89 = 178
Third purchase (December 2010) 1 @ 90 =     90
Total goods available for sale 5 $440
Less: Inventory at Dec. 31, 2010 4 @ $88 – 352
Cost of goods sold 1 @ $88 $  88

Since the bookstore sold only one book, the cost of goods sold is $88 (1 x $88). The four books still on hand are reported at $352 (4 x $88) of cost in the Inventory account. The total of the cost of goods sold plus the cost of the inventory should equal the total cost of goods available ($88 + $352 = $440).

If Bookstore sells the textbook for $110, its gross profit under the periodic average method will be $22 ($110 – $88). This gross profit is between the $25 computed under periodic FIFO and the $20 computed under periodic LIFO.

B1. Perpetual FIFO

Under the perpetual system the Inventory account is constantly (or perpetually) changing. When a retailer purchases merchandise, the retailer debits its Inventory account for the cost; when the retailer sells the merchandise to its customers its Inventory account is credited and its Cost of Goods Sold account is debited for the cost of the goods sold. Rather than staying dormant as it does with the periodic method, the Inventory account balance is continuously updated.

Under the perpetual system, two transactions are recorded when merchandise is sold: (1) the sales amount is debited to Accounts Receivable or Cash and is credited to Sales, and (2) the cost of the merchandise sold is debited to Cost of Goods Sold and is credited to Inventory. (Note: Under the periodic system the second entry is not made.)

With perpetual FIFO, the first (or oldest) costs are the first moved from the Inventory account and debited to the Cost of Goods Sold account. The end result under perpetual FIFO is the same as under periodic FIFO. In other words, the first costs are the same whether you move the cost out of inventory with each sale (perpetual) or whether you wait until the year is over (periodic).

B2. Perpetual LIFO

Under the perpetual system the Inventory account is constantly (or perpetually) changing. When a retailer purchases merchandise, the retailer debits its Inventory account for the cost of the merchandise. When the retailer sells the merchandise to its customers, the retailer credits its Inventory account for the cost of the goods that were sold and debits its Cost of Goods Sold account for their cost. Rather than staying dormant as it does with the periodic method, the Inventory account balance is continuously updated.

Under the perpetual system, two transactions are recorded at the time that the merchandise is sold: (1) the sales amount is debited to Accounts Receivable or Cash and is credited to Sales, and (2) the cost of the merchandise sold is debited to Cost of Goods Sold and is credited to Inventory. (Note: Under the periodic system the second entry is not made.)

With perpetual LIFO, the last costs available at the time of the sale are the first to be removed from the Inventory account and debited to the Cost of Goods Sold account. Since this is the perpetual system we cannot wait until the end of the year to determine the last cost—an entry must be recorded at the time of the sale in order to reduce the Inventory account and to increase the Cost of Goods Sold account.

If costs continue to rise throughout the entire year, perpetual LIFO will yield a lower cost of goods sold and a higher net income than periodic LIFO. Generally this means that periodic LIFO will result in less income taxes than perpetual LIFO. (If you wish to minimize the amount paid in income taxes during periods of inflation, you should discuss LIFO with your tax adviser.)

Once again we’ll use our example for the Bookstore:

Number of Books Cost per Book Total Cost
Inventory at Dec. 31, 2009 1 @ $85 = $  85
First purchase (January 2010) 1 @ 87 = 87
Second purchase (June 2010) 2 @ 89 = 178
Third purchase (December 2010) 1 @ 90 =     90
Total goods available for sale 5 $440
Less: Inventory at Dec. 31, 2010 4 – 351
Cost of goods sold 1 @ $89 $  89

Let’s assume that after the Bookstore makes its second purchase in June 2010, the Bookstore sells one book. This means the last cost at the time of the sale was $89. Under perpetual LIFO the following entry must be made at the time of the sale: $89 will be credited to Inventory and $89 will be debited to Cost of Goods Sold. If that was the only book sold during the year, at the end of the year the Cost of Goods Sold account will have a balance of $89 and the cost in the Inventory account will be $351 ($85 + $87 + $89 + $90).

If the bookstore sells the textbook for $110, its gross profit under perpetual LIFO will be $21 ($110 – $89). Note that this is different than the gross profit of $20 under periodic LIFO.

B3. Perpetual Average

Under the perpetual system the Inventory account is constantly (or perpetually) changing. When a retailer purchases merchandise, the costs are debited to its Inventory account; when the retailer sells the merchandise to its customers the Inventory account is credited and the Cost of Goods Sold account is debited for the cost of the goods sold. Rather than staying dormant as it does with the periodic method, the Inventory account balance under the perpetual average is changing whenever a purchase or sale occurs.

Under the perpetual system, two sets of entries are made whenever merchandise is sold: (1) the sales amount is debited to Accounts Receivable or Cash and is credited to Sales, and (2) the cost of the merchandise sold is debited to Cost of Goods Sold and is credited to Inventory. (Note: Under the periodic system the second entry is not made.)

Under the perpetual system, “average” means the average cost of the items in inventory as of the date of the sale. This average cost is multiplied by the number of units sold and is removed from the Inventory account and debited to the Cost of Goods Sold account. We use the average as of the time of the sale because this is a perpetual method. (Note: Under the periodic system we wait until the year is over before computing the average cost.)

Let’s use the same example again for the Bookstore:

Number of Books Cost per Book Total Cost
Inventory at Dec. 31, 2009 1 @ $85 = $      85
First purchase (January 2010) 1 @ 87 = 87
Second purchase (June 2010) 2 @ 89 = 178
Third purchase (December 2010) 1 @ 90 =         90
Total goods available for sale 5 $440.00
Less: Inventory at Dec. 31, 2010 4 @ $88.125 – 352.50
Cost of goods sold 1 @ $87.50 $  87.50

Let’s assume that after The Bookstore makes its second purchase, The Bookstore sells one book. This means the average cost at the time of the sale was $87.50 ([$85 + $87 + $89 + $89] ÷ 4]). Because this is a perpetual average, a journal entry must be made at the time of the sale for $87.50. The $87.50 (the average cost at the time of the sale) is credited to Inventory and is debited to Cost of Goods Sold. After the sale of one unit, three units remain in inventory and the balance in the Inventory account will be $262.50 (3 books at an average cost of $87.50).

After The Bookstore makes its third purchase, the average cost per unit will change to $88.125 ([$262.50 + $90] ÷ 4). As you can see, the average cost moved from $87.50 to $88.125—this is why the perpetual average method is sometimes referred to as the moving average method. The Inventory balance is $352.50 (4 books with an average cost of $88.125 each).

Comparison of Cost Flow Assumptions
Below is a recap of the varying amounts for the cost of goods sold, gross profit, and ending inventory that were calculated above.

             Periodic                         Perpetual           
FIFO LIFO Avg. FIFO LIFO Avg.
Sales $110 $110 $110 $110 $110 $110.00
Cost of Goods Sold  – 85  – 90  – 88  – 85  – 89  – 87.50
Gross Profit $  25 $   20 $  22 $  25 $  21 $  22.50
Ending Inventory $355 $350 $352 $355 $351 $352.50

There are two methods for estimating ending inventory:

1.   Gross Profit Method
2.   Retail Method

1.  Gross Profit Method. The gross profit method for estimating inventory uses the information contained in the top portion of a merchandiser’s multiple-step income statement:

ABC Company
Income Statement (partial)
For the Year Ended Dec. 31, 2009

Sales $100,000 100.0%
Cost of Goods Sold
Beginning Inventory $ 22,000
Purchases – net    83,000
Cost of Goods Available 105,000
Less: Ending Inventory    25,000
Cost of Goods Sold    80,000   80.0%
Gross Profit $ 20,000   20.0%

Let’s assume that we need to estimate the cost of inventory on hand on June 30, 2010. From the 2009 income statement shown above we can see that the company’s gross profit is 20% of the sales and that the cost of goods sold is 80% of the sales. If those percentages are reasonable for the current year, we can use those percentages to help us estimate the cost of the inventory on hand as of June 30, 2010.

While an algebraic equation could be constructed to determine the estimated amount of ending inventory, we prefer to simply use the income statement format. We prepare a partial income statement for the period beginning after the date when inventory was last physically counted, and ending with the date for which we need the estimated inventory cost. In this case, the income statement will go from January 1, 2010 until June 30, 2010.

Some of the numbers that we need are easily obtained from sales records, customers, suppliers, earlier financial statements, etc. For example, sales for the first half of the year 2010 are taken from the company’s records. The beginning inventory amount is the ending inventory reported on the December 31, 2009 balance sheet. The purchases information for the first half of 2010 is available from the company’s records or its suppliers. The amounts that we have available are written in italics in the following partial income statement:

ABC Company
Income Statement (partial)
For the Six Months Ended June 30, 2010

Sales $ 56,000 100.0%
Cost of Goods Sold
Beginning Inventory $ 25,000
Purchases – net 46,000
Cost of Goods Available
Less: Ending Inventory
Cost of Goods Sold  80.0%
Gross Profit  20.0%

We will fill in the rest of the statement with the answers to the following calculations. The amounts in italics come from the statement above. The bold amount is the answer or result of the calculation.

Step 1. Cost of Goods Available = Beginning Inventory + Net Purchases
Cost of Goods Available = $25,000 + $46,000
Cost of Goods Available =     $71,000
Step 2. Gross Profit = Gross Profit Percentage (or Gross Margin) x Sales
Gross Profit = 20% x $56,000
Gross Profit =      $11,200
Step 3. Cost of Goods Sold = Sales   Gross Profit
Cost of Goods Sold = $56,000   $11,200  (from Step 2.)
Cost of Goods Sold = $44,800

This can also be calculated as 80%  x  Sales of  $56,000  =  $44,800.

Inserting this information into the income statement yields the following:

ABC Company
Income Statement (partial)
For the Six Months Ended June 30, 2010

Sales $56,000 100.0%
Cost of Goods Sold
Beginning Inventory $25,000
Purchases – net   46,000
Cost of Goods Available 71,000
Less: Ending Inventory            ?
Cost of Goods Sold   44,800  80.0%
Gross Profit $11,200  20.0%

As you can see, the ending inventory amount is not yet shown. We compute this amount by subtracting cost of goods sold from the cost of goods available:

Ending Inventory = Cost of Goods Available Cost of Goods Sold
Ending Inventory = $71,000 $44,800
Ending Inventory =        $26,200

Below is the completed partial income statement with the estimated amount of ending inventory at $26,200. (Note: It is always a good idea to recheck the math on the income statement to be certain you computed the amounts correctly.)

ABC Company
Income Statement (partial)
For the Six Months Ended June 30, 2010

Sales $56,000 100.0%
Cost of Goods Sold
Beginning Inventory $25,000
Purchases – net   46,000
Cost of Goods Available 71,000
Less: Ending Inventory   26,200
Cost of Goods Sold   44,800  80.0%
Gross Profit $11,200  20.0%

2.  Retail Method. The retail method can be used by retailers who have their merchandise records in both cost and retail selling prices. A very simple illustration for using the retail method to estimate inventory is shown here:

Cost Retail
Beginning Inventory $ 11,000 $ 15,000
Purchases – net + 69,000 + 85,000
Goods Avail. & Cost Ratio 80,000 100,000
Less: Sales at retail  – 90,000
Est. ending inventory at retail 10,000
Est. ending inventory at cost $   8,000

As you can see, the cost amounts are arranged into one column. The retail amounts are listed in a separate column. The Goods Available amounts are used to compute the cost-to-retail ratio. In this case the cost of goods available of $80,000 is divided by the retail amount of goods available ($100,000). This results in a cost-to-retail ratio, or cost ratio, of 80%.

To arrive at the estimated ending inventory at cost, we multiply the estimated ending inventory at retail ($10,000) times the cost ratio of 80% to arrive at $8,000.

Sources: accountingcoach

 

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