Cost of goods sold Study Guide

📖 Core Concepts Cost of Goods Sold (COGS) – The carrying value of goods actually sold in an accounting period; includes purchase, conversion, and other costs needed to bring inventory to its present condition. Inventory Cost Components – Materials, direct labor (including payroll taxes/benefits), and allocated overhead (factory rent, utilities, depreciation). Cost Flow Assumptions – Methods used to assign costs to specific goods sold: FIFO, LIFO, Average Cost, Specific Identification, Retail Method, etc. Lower of Cost or Market (LCM) – Inventory must be reported at the lesser of historical cost or current net realizable value. Period vs. Product Costs – Costs directly tied to inventory become part of COGS; operating expenses (e.g., purchasing department, warehouse, post‑sale shipping) are period costs. --- 📌 Must Remember COGS Formula: $$\text{COGS} = \text{Beginning Inventory} + \text{Purchases} - \text{Ending Inventory}$$ Purchase Cost Inclusions: Purchase price, freight, customs duties, non‑recoverable taxes, acquisition fees. Purchase Cost Exclusions: Trade/manufacturer/cash discounts, recoverable VAT. LIFO Reserve: Separate balance showing the cumulative difference between FIFO and LIFO valuations. Gross Margin: $$\text{Gross Margin} = \text{Sales Revenue} - \text{COGS}$$ Write‑Down Effect: Reduces current‑period net income and ending‑inventory balance. Standard Cost Variance: Recorded when actual material/labor costs differ from standard; variance allocated between COGS and ending inventory. --- 🔄 Key Processes Determine COGS (periodic system): Add beginning inventory to purchases (including all purchase‑cost components). Subtract ending inventory (valued using chosen cost flow method). Apply Cost Flow Assumption: FIFO: Use oldest costs first. LIFO: Use most recent costs first; update LIFO reserve. Average Cost: Compute weighted average unit cost → multiply by units sold. Specific Identification: Match each sold unit to its exact recorded cost. Write‑Down Inventory (LCM test): Compare cost to market value. If market < cost, record expense = cost – market; adjust ending inventory. Allocate Overhead (traditional): Choose driver (e.g., labor hours, machine hours). Compute burden rate = total overhead ÷ total driver units. Apply rate to each product’s driver usage. --- 🔍 Key Comparisons FIFO vs. LIFO FIFO → oldest costs → higher inventory value in inflationary periods, higher net income. LIFO → newest costs → lower inventory value, lower net income, tax advantage (US). Average Cost vs. FIFO/LIFO Average smooths price fluctuations; FIFO/LIFO reflect actual flow assumptions. Period Cost vs. Product Cost Period cost: purchasing dept., warehouse, post‑sale shipping → expensed when incurred. Product cost: materials, direct labor, overhead → capitalized in inventory, become COGS when sold. Trade Discount vs. Cash Discount Both reduce purchase cost, but trade discount is deducted from list price; cash discount is earned for early payment. --- ⚠️ Common Misunderstandings “All shipping costs belong to COGS.” – Only freight to acquire inventory is included; shipping after sale is a period expense. “VAT is always part of COGS.” – Recoverable VAT is excluded; only non‑recoverable sales/use taxes are included. “LIFO always yields lower taxes.” – Only true when prices are rising; if prices fall, LIFO can increase taxable income. “Write‑offs only happen for damaged goods.” – Entire inventory loss (e.g., fire) is also a write‑off. --- 🧠 Mental Models / Intuition “Match‑Revenue” Box: Imagine COGS as the “cost side” of the revenue‑matching box; every dollar of sales pulls a dollar of cost out of inventory. “Layer Cake” for LIFO/FIFO: Visualize inventory layers by acquisition date; FIFO peels off the bottom layer, LIFO slices the top layer. “Cost‑to‑Retail Ratio” Shortcut: For the retail method, think of a single multiplier (cost ÷ retail) that converts any retail value to cost. --- 🚩 Exceptions & Edge Cases US Tax vs. Financial Reporting: Some period costs (e.g., certain warehouse expenses) must be capitalized for tax but not for GAAP. Non‑recoverable Sales Tax: Included in COGS only when the tax cannot be claimed as an input credit. LIFO Reserve Disclosure: Required for public companies to show the impact of switching to FIFO. --- 📍 When to Use Which Choose FIFO when inventory is perishable or when you want higher reported profit in inflationary periods. Choose LIFO for tax‑saving strategies in rising price environments (US only). Choose Average Cost for large homogeneous inventory where tracking each layer is impractical. Use Specific Identification for high‑value, low‑volume items (e.g., automobiles, jewelry). Apply Retail Method when only retail price data are readily available (e.g., retail chains). --- 👀 Patterns to Recognize Price Trend + Inventory Method = Income Swing: Rising prices + LIFO → lower net income; falling prices + FIFO → lower net income. Variance Spotting: When actual costs exceed standard, expect a debit to COGS (unfavorable variance). Write‑Down Trigger: Any mention of “defective,” “obsolete,” or “market decline” signals an LCM test. --- 🗂️ Exam Traps Distractor: Including post‑sale shipping in COGS – remember it’s an operating expense. Distractor: Adding recoverable VAT to inventory cost – it should be excluded. Distractor: Assuming all overhead is allocated by a single rate – activity‑based costing may be required if the question specifies cost drivers. Distractor: Treating trade discounts as a separate expense – they directly reduce purchase cost. ---