Closing Inventory and the
Cost of Goods Sold Formula

Now, let’s look at a summary of the figures we have calculated from these three methods: 

We can work out some very useful formulas using these figures…

The closing inventories can always be calculated as follows:

If we switch around the equation to make cost of goods sold the subject, we have a formula for working this out:

Try these two formulas using the above table and you will see that they work every time.

For example, with the FIFO figures, we can see that we had 0 inventories to start with, plus we purchased $1,800 worth of goods. Of these $1,800, we sold $700, so we were left with $1,100 closing inventories. Using the same figures, we can see that we purchased $1,800 worth of goods and were left with $1,100, so we must have sold $700 worth of goods (the cost of goods that we sold).

The last formula above is actually well known - it is called the cost of goods sold formula or the cost of sales formula.

Almost every accounting student I have encountered has had to memorize this formula because they simply didn't understand what it means and how it works in practice. The explanations above should make it easier for you to understand and work with this key formula.

Once we have calculated our gross profit from the sales and cost of goods sold, we add other income to this and deduct general business expenses from this, to arrive at our net profit

Simple Summary

• The perpetual method of inventory involves tracking each individual item of inventory on a minute-to-minute basis. It can be expensive to implement, but it improves and simplifies accounting.
• The periodic method of inventory involves doing an inventory count at the end of each period, then mathematically calculating Cost of Goods Sold.
• FIFO (first-in, first-out) is the assumption that the oldest units of inventory are sold before the newer units.
• LIFO (last-in, first-out) is the opposite assumption: The newest units of inventory are sold before older units are sold.
• The average cost method is a formula for calculating CoGS and ending inventory based upon the average cost per unit of inventory available for sale over a given period.

Average Cost

The average cost method is just what it sounds like. It uses the beginning inventory balance and the purchases over the period to determine an average cost per unit. That average cost per unit is then used to determine both the CoGS and the ending inventory balance.

[Beginning Inventory + Purchases (in tk)]
÷ [Beginning Inventory + Purchases (in units)]
= Average Cost per Unit

Average Cost per Unit x Units Sold = Cost of Goods Sold

Avgerage Cost per Unit x Units in Ending Inventory = Ending Inventory Balance

EXAMPLE (CONTINUED): Under the average cost method, Maggie’s average cost per shirt for April is calculated as follows:

Beginning Inventory: 50 shirts (tk3/shirt)
Purchases: 100 shirts (60 at tk3/shirt and 40 at tk3.50/shirt)

Her total units available for sale over the period is 150 shirts. Her total Cost of Goods Available for Sale is tk470 (110 shirts at tk3 each and 40 at tk3.50 each).

Maggie’s average cost per shirt = tk470/150 = tk3.13

Using an average cost/shirt of tk3.13, we can calculate the following:

• CoGS in April = tk313 (100 shirts x tk3.13/shirt)
• Ending Inventory = tk157 (50 shirts x tk3.13/shirt)

Assumptions Used in Calculating CoGS under the Periodic Method

Of course, the calculation of CoGS is a bit more complex out in the real world. For example, if a business is dealing with changing per-unit inventory costs, assumptions have to be made as to which ones were sold (the cheaper units or the more expensive units).

EXAMPLE: Maggie has a business selling t-shirts online. She gets all of her inventory from a single vendor. In the middle of April, the vendor raises its prices from $3 per shirt to $3.50 per shirt. If Maggie sells 100 shirts during April—and she has no way of knowing which of those shirts were purchased at which price—should her CoGS be $300, $350, or somewhere in between?

The answer depends upon which inventory-valuation method is used. The three most used methods are known as FIFO, LIFO, and Average Cost. Under GAAP, a business can use any of the three.

First-In, First-Out (FIFO)

Under the “First-In, First-Out” method of calculating CoGS, we assume that the oldest units of inventory are always sold first. So in the above example, we’d assume that Maggie sold all of her $3 shirts before selling any of her $3.50 shirts.

Last-In, First-Out (LIFO)

Under the “Last-In, First-Out” method, the opposite assumption is made. That is, we assume that all of the newest inventory is sold before any older units of inventory are sold. So, in the above example, we’d assume that Maggie sold all of her $3.50 shirts before selling any of her $3 shirts.

EXAMPLE (CONTINUED): At the beginning of April, Maggie’s inventory consisted of 50 shirts—all of which had been purchased at $3 per shirt. Over the month, she purchased 100 shirts, 60 at $3 per shirt, and 40 at $3.50 per shirt. In total, Maggie’s Goods Available for Sale for April consists of 110 shirts at $3 per shirt, and 40 shirts at $3.50 per shirt.

If Maggie were to use the FIFO method of calculating her CoGS for the 100 shirts she sold in April, her CoGS would be $300. (She had 110 shirts that cost $3, and FIFO assumes that all of the older units are sold before any newer units are sold.)

100 x 3 = 300

If Maggie were to use the LIFO method of calculating her CoGS for the 100 shirts she sold in April, her CoGS would be $320. (LIFO assumes that all 40 of the newer, $3.50 shirts would have been sold, and the other 60 must have been $3 shirts.)

(40 x 3.5) + (60 x 3) = 320

It’s worth pointing out that the two methods result not only in different Cost of Goods Sold for the period, but in different ending inventory balances as well.

Under FIFO—because we assumed that all 100 of the sold shirts were the older, $3, shirts—it would be assumed that, at the end of April, her 50 remaining shirts would be made up of 10 shirts that were purchased at $3 each, and 40 that were purchased at $3.50 each. Grand total ending inventory balance: $170.

In contrast, the LIFO method would assume that—because all of the newer shirts were sold—the remaining shirts must be the older, $3 shirts. As such, Maggie’s ending inventory balance under LIFO is $150.

How to Calculate Cost of Goods Sold (CoGS)

The following is an excerpt from Accounting Made Simple: Accounting Explained in 100 Pages or Less.

When using the periodic method of inventory, Cost of Goods Sold is calculated using the following equation:

Beginning Inventory + Inventory Purchases – End Inventory = Cost of Goods Sold

This equation makes perfect sense when you look at it piece by piece.

Beginning inventory, plus the amount of inventory purchased over the period gives you the total amount of inventory that could have been sold (sometimes known, understandably, as Cost of Goods Available for Sale).

We then assume that, if an item isn’t in inventory at the end of the period, it must have been sold. (And conversely, if an item is in ending inventory, it obviously wasn’t sold, hence the subtraction of the ending inventory balance when calculating CoGS).

EXAMPLE: Corina has a business selling books on eBay. An inventory count at the beginning of November shows that she has $800 worth of inventory on hand. Over the month, she purchases another $2,400 worth of books. Her inventory count at the end of November shows that she has $600 of inventory on hand.

Using the equation above, we learn that Corina’s Cost of Goods Sold for November is $2600, calculated as follows:

Beginning Inventory	+	Purchases	-	Ending Inventory	=	Cost of Goods Sold
800	+	2400	-	600	=	2600

Granted, this equation isn’t perfect. For instance, it doesn’t keep track of the cost of inventory theft. Any stolen items will accidentally get bundled up into CoGS, because:

1. They aren’t in inventory at the end of the period, and
2. There is no way to know which items were stolen as opposed to sold, because inventory isn’t being tracked item-by-item.

DEFINITION OF 'COST OF GOODS SOLD - COGS'

The direct costs attributable to the production of the goods sold by a company. This amount includes the cost of the materials used in creating the good along with the direct labor costs used to produce the good. It excludes indirect expenses such as distribution costs and sales force costs. COGS appears on the income statement and can be deducted from revenue to calculate a company's gross margin. Also referred to as "cost of sales."

Read more: http://www.investopedia.com/terms/c/cogs.asp#ixzz3dmCSzBsM 

Follow us: @Investopedia on Twitter

1. What is prime cost? | AccountingCoach

1. Prime cost is the combination of a manufactured product's costs of direct materials and direct labor. In other words, prime cost refers to the direct production costs. Indirect manufacturing costs are not part ofprime cost.