5.03 – Looking Deeper into the “Cost of Goods Sold” Expense
Understanding Cost of Goods Sold (COGS)
Small business owners often accept cost amounts reported by accountants at face value, assuming these amounts are the definitive costs. However, it’s important to approach these figures with the same scrutiny you would apply to other business information. Just as you would read between the lines of employee complaints or dubious customer excuses, it’s crucial to be equally discerning with reported expenses.
Uniform accounting standards for financial reporting are essential, yet there is still debate within the accounting profession regarding the best methods for recording certain expenses. For instance, businesses can choose between the straight-line and accelerated methods for depreciation. Similarly, different methods exist for recording the cost of goods sold (COGS).
Selecting a Cost of Goods Sold Expense Method
COGS is typically the largest expense for businesses that sell products, often accounting for more than 50% of sales revenue. Despite its significance, there is no single agreed-upon method for recording this expense. Businesses can choose from several methods, each impacting financial statements differently.
The choice of method can affect both the COGS expense reported and the book value of inventory. Common methods include:
- First-In, First-Out (FIFO): This method assumes the oldest inventory items are sold first. The ending inventory value reflects the cost of the most recent purchases.
- Last-In, First-Out (LIFO): This method assumes the newest inventory items are sold first. The ending inventory value can reflect older costs, potentially underestimating current replacement costs.
- Average Cost: This method averages the cost of all inventory items, providing a middle ground between FIFO and LIFO.
The method chosen can influence financial outcomes. For instance, during periods of rising prices, FIFO will result in lower COGS and higher reported profits compared to LIFO.
Dealing with Inventory Shrinkage and Write-Downs
Beyond selecting a COGS method, businesses must also manage inventory shrinkage and write-downs. Inventory shrinkage refers to losses from theft, damage, deterioration, or recording errors. Conducting a physical inventory count, usually at the fiscal year’s end, helps identify and account for these losses.
Additionally, businesses should perform a “lower of cost or market” test on their ending inventory. This involves comparing product costs against current replacement costs and market prices. If either has dropped, an adjusting entry should be made to write down the inventory to its lower value. This ensures the inventory is not overstated on the balance sheet.
Inventory shrinkage and write-downs should be recorded as expenses, typically included in COGS. However, significant losses should be highlighted, either as a separate line item in the income statement or in a footnote, to ensure transparency.
