Accounting For Dummies®, 4th Edition

7.3. Calculating Cost of Goods Sold and Cost of Inventory

One main accounting decision that must be made by companies that sell products is which method to use for recording the cost of goods sold expense, which is the sum of the costs of the products sold to customers during the period. You deduct cost of goods sold from sales revenue to determine gross margin — the first profit line on the income statement (refer to Figure 7-1). Cost of goods sold is a very important figure, because if gross margin is wrong, bottom-line profit (net income) is wrong.

A business acquires products either by buying them (retailers and distributors) or by producing them (manufacturers). Chapter 11 explains how manufacturers determine product cost; for retailers, product cost is simply purchase cost. (Well, it's not entirely this simple, but you get the point.) Product cost is entered in the inventory asset account and is held there until the products are sold.

When a product is sold, but not before, the product cost is taken out of inventory and recorded in the cost of goods sold expense account. You must be absolutely clear on this point. Suppose that you clear $700 from your salary for the week and deposit this amount in your checking account. The money stays in your bank account and is an asset until you spend it. You don't have an expense until you write a check.

Likewise, not until the business sells products does it have a cost of goods sold expense. When you write a check, you know how much ...