Is cost of goods sold a debit or credit? Transactions are usually recorded in accounting as a debit or credit entry. For every transaction, an amount must be recorded in one account as a credit (right side of the balance sheet) and recorded in another account as a debit (left side of the balance sheet). This system is a double-entry accounting system that provides accuracy in accounting records and financial statements.
The cost of goods sold (COGS) is usually recorded as an expense in the income statement that reports the business’ profits and losses. This financial statement shows the sales, expenses, and net income of the business. The COGS on the income statement is the amount that includes the cost of the materials and labor directly used to create goods. Therefore, to get a business’s gross profit, the cost of goods sold is subtracted from the revenue of the business. Knowing the COGS of a business helps determine the company’s net income and calculate net profit.
Since the cost of goods sold is treated as an expense in financial reports; will it be recorded as a debit or credit in the double-entry system? In this article, we will discuss the cost of goods sold as a debit and not a credit entry. But first, let’s look at what debits and credits mean in accounting.
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Understanding debit and credit
The financial statement of a company reflects every monetary impact of a business transaction. When accounting for any transaction, the numbers are reported in two or three accounts either as a debit or credit entry. Regardless of the account, the credit column is usually positioned on the right-hand side of the ledger while the debit column is positioned on the left-hand side of the ledger.
Therefore, credit and debit signify actual accounting functions which cause decreases and increases in accounts, depending on the type of account. In accounting, the transaction recorded will either have a debit or credit balance, and for every amount recorded as a credit in one account, the same amount is recorded as a debit in another account.
A debit entry will either increase an expense or asset account and decrease an equity or liability account. A credit entry, on the other hand, increases equity or liability accounts and decreases an expense or asset account. That is, when an asset is increased, the change is a debit entry. Conversely, an increase in liabilities will be a credit entry because it signifies an amount that has been used to purchase something (which is the cause of the corresponding debit in the assets account).
All accounts with a natural debit balance will increase in amount when a debit entry (left column) is added to them and decrease in amount when a credit entry (right column) is added to them. Dividends, expenses, and assets are the types of accounts that increase with debit and decrease with credit.
Conversely, all accounts with a natural credit balance will increase in amount when a credit entry (right column) is added to them and decrease in amount when a debit entry (left column) is added to them. Revenues, liabilities, and equity are the type of accounts that increase with credit and decrease with debit. Also, all accounts can be credited or debited depending on the kind of transaction that takes place.
Therefore, for every transaction, a credit entry in one account will require a debit entry in another account. This accounting system is said to be a double-entry system that provides accuracy in accounting records and financial statements.
In a balance sheet or ledger, according to Pacioli’s method of bookkeeping or double-entry accounting, assets equal liabilities plus shareholders’ equity. This means that an increase in the value of assets would be a debit to the asset account and a decrease would be a credit to the asset account. An increase in liabilities/shareholders’ equity, on the other hand, would be a credit to the account and a decrease would be a debit to the liabilities /shareholders’ equity account.
Bookkeepers use the double-entry accounting method (T-accounts) to enter each debit and credit in two accounts on the balance sheet. Hence, whenever an accounting transaction is recorded, two accounts are at least always affected with a debit entry being reported against one account and a credit entry reported against another account.
For instance, you write a rent cheque to your landlord. This transaction will warrant you to enter a credit for the bank account on which the cheque is drawn and then enter a debit in a rent expense account. Your landlord, on the other hand, would enter a debit for the bank account where the cheque is deposited and then enter a credit in the rent income account associated with the tenant.
In addition, whenever a company pays cash for an expense, a journal entry for this transaction would cause the expense account to increase with a debit, and the cash paid will decrease with a credit. In T-accounts, each transaction is recorded in at least two accounts; one debit and one credit. These recordings are journal entries, with debits and credits that either increase or decrease a given account. This is why the accounting system is said to be a double-entry system.
The use of debits and credits in the two-column transaction recording format is very important for accounting accuracy. Nonetheless, a transaction may involve more than two accounts, for instance, when a company pays back a loan to the bank, three accounts would be involved. These accounts involve Cash accounts, Notes Payable accounts, and Interest Expense accounts.
In general, the total amount of credits must equal the total amount of debits in a transaction. If not, the accounting transaction would be said to be unbalanced and when transactions are unbalanced, it is impossible to create financial statements.
Conclusively, when recording business transactions, accounts could be classified and treated either as an asset, expense, liability, revenue, contra account, shareholders’ equity, or dividend account. Each of these account transactions can be recorded in a double entry system as a credit to one account and a debit to another account using the modern or traditional approaches in accounting.
On the balance sheet, cash, inventory, and accounts receivable are considered asset accounts and therefore increase with debits. For liabilities, the account increases with credits. On the income statement, revenues are known to decrease with debits and increase with credits. Whereas, expenses increase with debits and decrease with credits. The cost of goods sold which is our main focus is treated as an expense account and so would have a natural debit balance as other expenses.
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What is cost of goods sold (COGS)?
Cost of goods sold (COGS) also known as cost of sales is the direct cost of producing the goods that are sold by a company. It is the amount that includes the cost of the materials and labor that are directly used to create the goods. Hence, COGS excludes indirect expenses, such as sales force costs and distribution costs.
COGS is, therefore, the cost of manufacturing or acquiring the goods and products that a company sells during a period. This means that the only costs included in the measure of COGS are those that are directly tied to the production of the products, which includes the cost of material, and labor, excluding indirect costs like distribution and sales expenses.
For instance, the cost of goods sold by an automaker would include the material costs for the parts that go into making the car plus the costs of labor used to put the car together. Therefore, the cost of sending the cars to dealerships and the cost of the labor used to sell the car would not be included.
Also, the costs incurred on the cars that were not sold during the year will not be included when calculating the COGS, regardless of whether the costs are direct or indirect. Therefore, the cost of goods sold only includes the direct cost of producing goods or services that were purchased by customers during the year.
The cost of goods sold is an important metric on financial statements. It is subtracted from the revenue of a company to determine its gross profit. The gross profit of a company is a profitability measure that evaluates how efficient the company is in managing its supplies and labor in the production process.
Since COGS is a cost of doing business, it is recorded on the income statement as a business expense. An expense account records all the increases in liabilities from delivering goods or services to customers or all the decreases in the owners’ equity that occur from the use of assets.
Expense accounts take account of the costs of doing business; all expenses incurred by a business during an accounting period such as cost for goods sold, expenses for bad debts, water, telephone, entertainment, electricity, repairs, wages, honorarium, rent, utility, fuel, salaries, depreciation, interest, stationery, etc.
The expenses account enables the company to organize and oversee the various expenses of its business over a certain duration of time. This account can be broken down into sub-accounts such as cost of goods sold for ordinary business operations, wages expenses, salary expenses, repairs and maintenance, rent expenses, payable interest, insurance rates, utilities, and bank charges/fees, etc so that one can clearly see where money is going and organize the finances accordingly.
The COGS entry records the total of all direct costs incurred during the production and/or sale of goods. COGS is the direct costs incurred on the production of goods manufactured and then sold. Hence, it only includes the directly associated costs of inventory and labor. Hence, knowing the COGS helps investors, analysts, and managers estimate the company’s bottom line (net income). If the COGS increases, the company’s net income will decrease. Even though this is beneficial for income tax purposes, the downside is that the business will have less profit for its shareholders. Hence, businesses try as much as possible to keep their COGS low so that net profits will be higher.
The purpose of cost accounting is to track the expenses that are involved in manufacturing or selling a product or service. Cost tracking and inventory systems would vary, depending on the product or service. Inventory is an essential part of calculating the cost of goods sold. From existing records, the beginning inventory figures can be drawn while the ending inventory sometimes requires a physical count. The journal entry for cost of goods sold is a calculation of the beginning inventory plus purchases, minus ending inventory.
Cost of goods sold (COGS) in Accounting
Cost of goods sold (COGS), sometimes called cost of sales, in accounting is a calculation of all the direct costs incurred on the production of goods manufactured and sold within a certain time period. It doesn’t include indirect costs like sales expenses and distribution. The costs of goods sold would vary as the number of finished products increases or decreases because the figure of COGS only includes the costs for the goods sold during the period and not the finished goods that are not yet sold.
An example of COGS in accounting can be explained as a company that sells 1,000 skin care products in a month at $10 each but bought the products for $2 each, The COGS for the skin care products would be $2,000 for the month, and gross profit would be $8,000.
Cost accounting methods usually vary from one industry to another. For instance, the cost of goods sold for a baker would be the cost of ingredients and labor if he/she has an assistant who helps produce the baked item for sale. Only the costs directly attributed to the sales are included in the COGS. Overhead costs such as utilities, rent, or the cost of delivering a wedding cake (delivery van, gas, driver) would not be included in the calculation of COGS.
When calculating COGS, inventory is an important consideration. Inventory consists of the finished products and merchandise awaiting sale, as well as raw materials and work-in-process. The formula for COGS is, therefore, expressed as:
COGS = Beginning Inventory + Purchases during the period – Ending Inventory
In the COGS formula, the unsold inventory from the previous year is considered the beginning inventory. Then, the purchases made throughout the year are added to the inventory to calculate COGS. Moreso, any unsold inventory at the end of the year is considered the ending inventory which is subtracted from the total of the beginning inventory and purchases to arrive at the COGS.
Let’s look at an example of how COGS is calculated:
Assume, a business’s beginning inventory is $2,000 and then the company purchase $500 worth of supplies during the period and the ending inventory is $200. The COGS calculation would look like this:
COGS = $2,000 + $500 – $200 = $2,300
i.e the cost of goods sold would be $2,300
Now, that we have an understanding of debit and credit entry as well as COGS; is cost of goods sold a debit or credit? The cost of goods sold is entered as a debit and not a credit. Let’s look at a further explanation below.
Is cost of goods sold a debit or credit?
The cost of goods sold is an expense account, so it is a debit entry. As an expense account, the cost of goods sold is increased by a debit entry and decreased by a credit entry. Therefore, when making a journal entry, the cost of goods sold is debited while purchases and inventory accounts are credited to balance the entry.
On the income statement, the cost of goods sold is an expense account, and hence, it is increased by debits and decreased by credits. Inventory and purchases as assets accounts will also increase by debits and decrease by credits. However, when making a journal entry, the cost of goods sold would be debited and purchases and inventory accounts would be credited. This shows that the assets have been sold and their costs have been moved to the COGS.
Hence, one account (COGS) is debited, and one or more other accounts (purchases and inventory accounts) are credited to balance the entry. The credits to purchases and inventory must equal the debit to COGS. Therefore, the journal entry for the cost of goods sold should equal purchases plus inventory.
Why is cost of goods sold a debit and not a credit? Recall that, credits serve to increase revenue, liability, or equity accounts while decreasing asset or expense accounts whereas, debits serve to increase assets or expense accounts while reducing revenue, liability, or equity accounts. Expenses cause the owner’s equity to decrease and as such COGS should have a debit balance.
At the end of the accounting year, the debit balances in the expense account will be closed and transferred to the owner’s capital account, thereby reducing the owner’s equity. At a corporation, the debit balance in the expense account will be closed and transferred to Retained Earnings, which is a stockholders’ equity account.
How to record the cost of goods sold journal entry
Before recording your COGS journal entries, collect information ahead of time, such as the purchased inventory costs, beginning inventory balance, overhead costs (e.g delivery fees), and ending inventory count. Then, calculate the COGS using the formula:
COGS = Beginning inventory + Purchases during the period – Ending inventory
After that, create a journal entry for your COGS. Ensure to adjust the inventory account balance to match the ending inventory total. Therefore, the cost of goods sold is a debit entry and not a credit entry. This means, when adding a COGS journal entry, you will debit your COGS Expense account and credit your Purchases and Inventory accounts. Inventory is the difference between the COGS Expense and Purchases accounts.
The COGS Expense account will be increased by debits and decreased by credits. Hence, when materials are purchased, credit the Purchases account to record the amount spent, debit the COGS Expense account to show an increase, and then credit the Inventory account to increase it.
Here is how the journal entry of COGS for materials purchased would look like:
|01/01/2022||COGS Expense||Materials purchased|
See also: Is Sales Discount Debit or Credit?
Examples to show how the cost of goods sold is a debit; not a credit
Let’s look at some examples to illustrate how the cost of goods sold has a natural debit balance and not a credit balance.
Assume Company ABC has a beginning balance in its Inventory account of $4,000. Say, the company purchase $1,000 worth of materials during the accounting period and at the end of the period, it counts $1,500 of ending inventory.
Calculating the COGS using the formula:
COGS = Beginning inventory + Purchases during the period – Ending inventory
$3,500 = $4,000 + $1,000 – $1,500
The $3,500 Cost of goods sold entry would be entered as follows:
|01/01/2022||COGS Expense||Materials purchased||$3,500|
As shown in the table above, the COGS expense account is debited by $3,500, $1,000 is credited to the Purchases account and the inventory account is credited with $2,500 ($3,500 COGS – $1,000 purchase).
Company XYZ has a beginning balance in its inventory asset account of $1,000,000. Say, during the month, the company buys materials from suppliers worth $350,000, which it records in the inventory account. At the end of the month, it counts its ending inventory and determines that there is $475,000 of inventory on hand.
In addition, Company XYZ incurs $150,000 of overhead costs, which it records in an overhead cost pool asset account.
In this instance given, there are now two COGS journal entries. The first COGS would be calculated as:
COGS = Beginning inventory ($1,000,000) + Purchases during the period ($350,000) – Ending inventory ($475,000) = $875,000
This COGS of $875,000 would be recorded as follows:
Recall that, there is $150,000 of overhead to allocate to the items produced during the month. Assume an analysis of produced items reveals that 1/3 were sold and 2/3 were retained in inventory.
i.e 1/3 of $150,000 of overhead costs = $50,000 COGS
2/3 of $150,000 of overhead costs = $100,000 inventory
Therefore, the second COGS (cost allocation) will be reported as follows:
|Cost of goods sold||$50,000|
|Overhead cost pool||$150,000|
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