Inventory and cost of goods sold (COGS) are one of the most important aspects of any business. COGS should, in principle, include the cost of all inventory sold during the fiscal period. In reality, however, businesses frequently do not know which inventory items are sold.
Rather, they depend on accounting principles like FIFO and LIFO principles to determine how much inventory was sold during the time. If the cost of inventory included in COGS is greater, the firm’s net income would be impacted. As a result, corporations may use accounting practices that result in a lower COGS ratio in order to increase their reported profits.
In this blog post, we will discuss the basics of inventory and COGS, including what they are and examples of how to calculate them. We will also differentiate the differences between the two of them. Read on to learn more!
The Definition Of Inventory
A company’s inventory consists of raw materials, work-in-process, and completed commodities. The inventory value of a corporation is normally recorded on the balance sheet. The inventory account is a liquid asset, which implies it will be sold or converted into money in a year’s time.
Companies frequently keep an excessive quantity of inventory on hand to run their operations. However, this might be difficult labor. Inventory levels must be regularly monitored. Keeping an excessive amount of inventory may result in cash flow issues. In contrast, holding too little of it might result in lost sales and clients due to a stockout issue.
Businesses employ a variety of strategies to track inventories. The two most prevalent approaches are first-in, first-out (FIFO) and last-in, first-out (LIFO). The first products obtained are the ones that will be sold first under the FIFO approach. The LIFO approach is the polar opposite. The most recently purchased things will be the first to be sold.
In all circumstances, businesses attempt to sell inventory in order to make money. Inventory serves as a productive resource until it is sold. When the product is sold, the cost becomes an expenditure known as the cost of goods sold. The cost is moved from the balance sheet to the income statement through journal entries.
The Definition Of Cost Of Goods Sold
The direct expenses of manufacturing the commodities sold by a corporation are referred to as the cost of goods sold (COGS). It is also known as the cost of sales. This figure comprises the cost of both the materials and labor necessary to make the item. It does not include secondary expenses like sales force expenses and distribution costs.
COGS is an essential financial statistic since it is removed from a company’s income to calculate net profit. The net income is a profit metric that assesses how well a firm manages its workers and materials during the manufacturing process.
COGS is considered a company expense on the revenue statements since it is a business cost. Analysts, managers, and investors can predict the business’s bottom line by knowing the cost of products sold. If COGS rises, net profit will fall. Although this change is advantageous for tax purposes, the corporation will generate lesser profit for its investors. Companies attempt to maintain their COGS low in order to increase their net income.
The COGS is the cost of obtaining or producing the items that a firm sells for a specific time, therefore the only costs in the metric would be those directly related to product creation, such as labor, resources, and production overhead.
Differentiate The Distinction Between Inventory And Cost Of Goods Sold
Seems like you understand the concepts of inventory and COGS, let’s take a glance at the fundamental distinctions between them:
- The balance sheet includes inventory, whereas the financial statements include COGS.
- A production budget contains all of its raw materials, work-in-progress, and completed commodities. COGS only reflects the direct expenses related to the manufacture of the sold items.
- The accounting system used by a corporation might have an impact on the value of inventories. The accounting technique utilized has no effect on the value of COGS.
- Inventory is a present commodity, but COGS is not. COGS is a cost that is subtracted from revenue to calculate net revenue.
Example Of Calculating Inventory And Cost Of Goods Sold
Let’s look at a scenario to better understand the distinction between inventory and COGS. Suppose that at the end of the fiscal year, company A has the below stock on hand:
Company A’s inventory
The inventory of company A is worth $90000 in total.
Imagine that company A sold $200000 in commodities throughout the fiscal year. The following were the direct costs involved with the manufacture of those goods:
Company A’s direct costs
Company A’s total COGS is $130,000. You will notice that the COGS covers both the cost of the inventory sold and the direct expenditures connected with producing those products.
To summarize, there is a significant distinction between the inventory and cost of goods sold. A business’s inventory consists of raw materials, work-in-process, and completed commodities while the COGS are the direct costs involved with the manufacture of items sold within a certain time. It is critical to grasp the distinction between these two notions in order to correctly control your company’s finances.