Study tips: Cost of goods sold

Do you know how to wire a plug?  

I’m not sure if you can even open a plug up anymore to see the wires inside, but if you can and did, then you would see that there are three:

  • the green and yellow earth one
  • the brown one which is live
  • and the blue neutral wire.

That knowledge is the foundation of being able to wire a plug.

You need to know it and understand what to do with it before you can move on to applying the skill of actually doing it. This may seem like a strange introduction to a study tips article but the links between knowledge, understanding and skills are the same.

The cost of goods sold equation

This article is actually about the cost of goods sold (COGS) equation and how to manipulate it to find missing figures when working on a set of incomplete records. It’s a challenging area as you first need to know what’s included, then understand why we calculate it and finally how to do it.

Once we have that sorted for a set of complete accounts, we then have to step up a level in the application of our understanding and skills, to start problem solving by manipulating the equation.

This is where the wiring of the plug comes in; as long as you know where two of the wires go then you can work out where the third belongs. In other words, if we have all but one of the COGS figures then as long as we understand how the equation works, we can always find the one that’s missing.

What we need to know

This is simply the equation plus the sub-calculation for net purchases.

opening inventory + net purchases – closing inventory = COGS

(purchases – purchase returns + carriage inwards = net purchases)

Why we calculate the COGS

Understanding why we calculate the COGS is probably the most difficult aspect of this subject.

The cost of goods sold is calculated in order to fulfil the requirements of the accruals concept. It’s part of the top section of the profit and loss statement and represents the expenditure that has been incurred in generating the sales in a financial period. Put another way, it’s the cost of the goods or services sold by the company, hence the term COGS.

The accruals concept is also responsible for the adjustments we need to make to the opening and closing inventory. As we’re ‘matching’ income and expenditure to a financial period regardless of when the money was paid or received, we have to deduct the value of the closing inventory as we haven’t sold it yet.

It can’t be matched to this period’s sales figure as it’s still on the shelf in the stockroom. However, it will be the first stock that gets sold in the new financial year. Therefore, last year’s closing inventory figure will become this year’s opening inventory figure, to which we will add this year’s net purchases and then deduct the closing inventory to give us this year’s COGS figure.

Once the cycle starts, it just continues year on year, but remember if your accounts are for a new business there won’t be any opening inventory in the first year of trading.

Once we know what is included in the COGS equation and understand its purpose, then using it is relatively easy. All we need are some basic maths skills in addition and subtraction.

Calculating COGS

Here’s an extract from a trial balance.

gill-1

From it we can calculate the net purchase as:

£31,979 – £3,880 + £700 = £28,799

Then we can calculate the COGS as:

£2,368 + £28,799 – £3,267 = £27,900

Finally we need to be able to ‘wire our plug’ and that involves applying all the knowledge, understanding and skills we have looked at so far.

Calculating closing inventory from the COGS equation

Here’s another extract from a trial balance, only this time the closing inventory figure is missing. However, we have been told that the COGS figure is £97,906. We need to calculate the closing inventory figure and to do that we have to manipulate the COGS equation.

gill-2

We can calculate the net purchases as before:

£120,673 – £23,561 + £1,567 = £98,679

Then we can use the layout of a profit and loss statement to help calculate the closing inventory:

gill-3

We know that the opening inventory is added to this year’s purchases £6,591 + £98,679 = £105,270

We also know that we need to deduct the closing inventory from the opening inventory and purchases to give the COGS figure.

Laid out in this way, we can see that the closing inventory is just the difference between the £105,270 and the £97,906. Therefore, closing inventory must be £7,364.

In summary

This is only one of a number of ways to manipulate the COGS equation so you’re unlikely to be successful in this area unless you understand the ‘whys’ as well as the ‘hows’. You may have been wondering where the COGS figure came from in the example above, especially as we didn’t have the value of the closing inventory.

We’ll tackle this in the upcoming study tips article on Margins and Mark ups, when we have a look at how the rest of the top section of a profit and loss statement works and why.

In the meantime don’t take apart a plug unless you’re a qualified electrician.

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Gill Myers is a self-employed accounts consultant. She has taught AAT qualifications since 2005 and written numerous articles and e-learning resources.

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