You need to ensure the accuracy of each costs of good sold journal entry if you want to be profitable. COGS is a major business expense, and errors in this area can really throw your numbers off.
What is Cost of Goods Sold (COGS)?
Definition of COGS
Your cost of Goods Sold (COGS) is the direct cost you entail for producing or acquiring the goods that you sell. It includes the cost of all the materials, labor, and overhead expenses that are directly related to the creation of these products.
COGS is a crucial component of your income statement. You use this to calculate your business’s gross profit. COGS directly impacts your profitability and cash flow.
Why is COGS important for ecommerce businesses?
COGS directly impacts profitability and cash flow. A lower COGS results in higher gross profit and better profitability. It’s also closely tied to inventory management, where accurate calculations means a better grasp of inventory levels and costs.
You need to understand COGS if you want to set competitive and profitable pricing. It’s also essential for calculating financial ratios like gross profit margin and inventory turnover. Errors mean you don’t get an accurate view of your business’s financial health or your taxable income. This can lead to costly mistakes and penalties.
What is a COGS Journal Entry?
Definition of a journal entry
A journal entry is basic to the accounting process. This is a chronological record of financial transactions in different accounts and their amounts. Each journal entry also includes the date of the transaction.
How COGS journal entries fit into your bookkeeping system
Each costs of good sold journal entry records the costs for specific periods. This directly impacts the calculation of gross profit.
When a business purchases inventory, You make a debit to the inventory account and a credit to the accounts payable or cash account. When you sell inventory, you note a debit to the COGS account and a credit to the inventory account.
If you make any inventory adjustments like write-offs or shrinkage, you create another journal entry to reflect each of these changes.
The Components of a COGS Journal Entry
Inventory Purchases
The basic costs of good sold journal entry for inventory purchases involves a debit and a credit. You debit the Inventory account and credit the Cash account for cash purchases or Accounts Payable for purchases on credit. You might need to make adjustments for purchase discounts, freight charges, sales tax, or returns and allowances.
If you use accounting software, look for features that automate inventory transactions. If you are dealing with a unique situation, consider consulting with an accountant or professional bookkeeper.
Direct Costs
Direct COGS are costs that are directly related to the production of the goods or services you sell.
The three primary categories are:
- Materials Costs, comprising raw materials used in production, and direct supplies for manufacturing, like glue and packaging materials.
- Shipping Costs, comprising inbound freight for transporting raw materials to the manufacturing facility, and outbound freight for shipping finished goods to customers.
- Labor Costs, comprising direct labor, which is wages and benefits paid to employees who are directly involved in the production process.
Recording Adjustments for Inventory
Adjustments to the costs of good sold journal entry for inventory include returns, damaged goods, and unsellable inventory.
Returns
An item returned before it’s sold means a debit to Inventory to increase the inventory count, and a credit to Cash or Accounts Payable. An item returned after it’s sold means a debit to Sales Returns and Allowances so it’s not included in your sales revenue. Then, you would also credit Inventory to reduce COGS.
Damaged Goods
An item damaged before it’s sold means a debit to an account specific to Loss from Damaged Inventory. Then, you would make a corresponding credit to Inventory to reduce inventory value. An item damaged after it’s sold means a debit to COGS to increase COGS and a credit to Inventory to reduce inventory value.
Unsellable Inventory
Inventory can become unsellable because of obsolescence, damage, or other reasons. Debit these items to an account specific to Loss from Unsalable Inventory and credit to Inventory to reduce inventory value.
Closing Inventory
Ending inventory is the value of the goods that remain unsold at the end of an accounting period. This directly impacts your COGS calculation for that period.
This costs of good sold journal entry can use the following simplified formula:
COGS = Beginning Inventory + Purchases – Ending Inventory
If you have higher ending inventory, your COGS will be lower. This means higher net income. If ending inventory is lower, your COGS will be higher and your net income lower.
Step-by-Step Guide: How to Record a COGS Journal Entry
Step 1: Determine Opening Inventory
Opening inventory is the value of the inventory that you have on hand at the beginning of an accounting period. You need this as a starting point to calculate COGS and determine your profitability.
This costs of good sold journal entry is basically a physical count of all inventory items. You would value each item using its cost, which is usually based on the purchase price. When a physical count is impractical or time-consuming, you can do an estimate of inventory based on calculations and assumptions.
If you use a perpetual inventory system, it would update your inventory records as purchases, sales, and adjustments happen.
Step 2: Add Purchases and Direct Costs
Recording Purchases
Cash and credit purchases require a debit to Inventory and a credit to either Cash or Accounts Payable.
Recording Direct Costs
The costs of good sold journal entry for materials and inbound shipping also involves a debit to Inventory and a credit to Cash or Accounts Payable.
Direct labor means a debit to an account specific to Work in Process when production is ongoing, or COGS when production is complete. Then, you would credit an account specific to Wages Payable.
Step 3: Calculate Ending Inventory
As with opening inventory, you can conduct a physical count of inventory items, or use a perpetual inventory system for automated updates. You would then use the system’s records to determine your ending balance.
Step 4: Record the Journal Entry
Below is an example of a basic costs of good sold journal entry for an ecommerce business.
Let’s say the business purchases $5,000 worth of products on credit. That means a debit to Inventory and a credit to Accounts Payable in the amount of $5,000.
Step 5: Post the COGS Entry in Your Books
You must make sure that each costs of good sold journal entry aligns with all your other financial reports.
Use the same inventory valuation method throughout each accounting period and from one period to the next. This helps you to avoid distortions in your COGS and net income. Do physical inventory counts on a schedule to verify the accuracy of your inventory records. Make adjustments as needed.
Make sure you accurately classify direct costs, which are traceable to products, versus indirect costs, which are allocated to products. Include all direct costs in COGS and indirect costs in Expenses. Make any necessary adjustments to COGS for returns, allowances, and damaged goods.
Reconcile Inventory with purchases and sales records on a schedule, and correct any discrepancies right away.
Common Mistakes to Avoid When Recording COGS
Double-counting inventory purchases
Double-counting inventory purchases can lead to inaccurate financial statements and overstated profits.
Here’s what you can do to prevent this:
- Maintain accurate records of all inventory purchases, including purchase orders, invoices, and receipts.
- Keep an organized system to track inventory movements and avoid duplication.
- Use a perpetual inventory system for real-time updates.
- Conduct regular physical inventory counts and make immediate adjustments for discrepancies.
- Set up internal controls like separating the responsibilities of purchasing, receiving, and accounting for inventory, and requiring proper authorization for all inventory purchases and adjustments.
Not adjusting for returns or unsellable goods
Failing to make a costs of good sold journal entry for returns or unsellable goods can lead to inaccurate financial statements and overstated profits.
Here’s what you can do to avoid this:
- Implement a clear return policy for acceptable returns backed by receipts or authorization.
- Maintain detailed records of all returns, allowances, and their reasons, and adjust inventory records immediately.
- Identify and dispose of damaged, expired, or obsolete goods on a schedule, and record them.
Misclassifying operational expenses as COGS
COGS are costs directly related to the production and sale of goods or services. Operational expenses are costs incurred in running the business, but not directly tied to product production or sale.
For example, COGS typically include materials, direct labor, and shipping costs. Operational expenses, however, include rent, utilities, and salaries of administrative staff.
To create the correct costs of good sold journal entry:
- Make sure your expense categories are correctly classified.
- Re-evaluate expenses on a schedule to make sure they align with current business operations.
- Document all expense allocations and make sure the justifications are clear and reasonable.
COGS and Tax Reporting
Why COGS is crucial for calculating taxable income
The IRS requires businesses to report COGS, a deductible expense, on their income tax returns. To accurately report COGS, you must use a consistent inventory valuation method. Make sure you keep supporting documentation for COGS, too.
This includes purchase invoices, shipping records, and inventory records.
Your COGS must match up to revenue in the same accounting period. Errors here and other failure to comply with IRS regulations can result in penalties and interest.
How to ensure accuracy in your tax filings
Make sure that each costs of good sold journal entry is accurate so you’re not overreporting or underreporting COGS. Overreporting results in a lower gross profit and net income, which means higher income tax liability. It also gives you a distorted idea of your business’s profitability.
Underreporting COGS, on the other hand, results in a higher gross profit and net income. This means underpaid income taxes and possible repercussions in case of an audit. It will also overstate profitability and hide inefficiencies that you should correct.
In severe cases, incorrect COGS reporting can lead to legal consequences damage to the business’s reputation. If you have investors, they can lose confidence.
How Often Should You Record COGS in Your Ecommerce Business?
Monthly, quarterly, or annually?
For a larger business, we generally recommend more frequent reporting so you can monitor performance and manage cash flow. Monthly COGS reporting gives you the most detailed view of business performance. This is also what is usually required for tax purposes.
Quarterly COGS reporting is more common for businesses with fewer transactions that still want to track performance over shorter periods. We don’t recommend annual COGS reporting, although small businesses with less stringent reporting needs can get away with it.
How to set up regular COGS tracking in your bookkeeping system
- Choose a COGS tracking method – perpetual inventory or periodic inventory.
- Identify COGS components – direct materials, direct labor, and manufacturing overhead.
- Set up inventory accounts – raw materials, work in process, finished goods, and COGS.
- Record purchases and costs – purchases, direct labor. manufacturing overhead.
- Transfer costs from inventory accounts to COGS at the end of the period or as products are sold, based on either periodic inventory and perpetual inventory.
- Adjust inventory and COGS for returns and allowances.
- Conduct regular inventory counts and make adjustments as necessary.
- Review and analyze COGS to identify trends, cost drivers, and areas for improvement.
Frequently Asked Questions
Can I adjust my COGS journal entry at the end of the fiscal year to correct discrepancies?
Yes, you can adjust for inventory count discrepancies, COGS calculations or journal entries, a change in inventory valuation method, etc. This process is called closing entries or adjusting entries.
How does COGS differ from operating expenses, and how do I ensure they’re properly separated in my books?
COGS are costs directly related to the production or purchase of goods or services sold. Operating Expenses are costs incurred in running the business, but not directly tied to product production or sale.
What is the difference between perpetual and periodic inventory systems for COGS recording?
A perpetual inventory system is automated, giving you continuous inventory updates as purchases, sales, and adjustments happen. A periodic inventory system requires physical counts at regular intervals.
How do changes in inventory valuation methods (FIFO, LIFO, weighted average) affect COGS entries?
When prices are going up, FIFO (First-In, First-Out) results in lower COGS and higher net income. LIFO (Last-In, First-Out), on the other hand, results in higher COGS and lower net income. Weighted Average provides a smoother COGS calculation since it averages the cost of all units purchased.
Can I record COGS differently if my ecommerce business uses dropshipping instead of holding inventory?
Since you don’t physically hold inventory, you can record each costs of good sold journal entry when the product is shipped to the customer. The cost of the product from the supplier is the direct cost, and shipping costs from the supplier to the customer would also be included in COGS.
What Is EcomBalance?
EcomBalance is a monthly bookkeeping service specialized for eCommerce companies selling on Amazon, Shopify, Ebay, Etsy, WooCommerce, & other eCommerce channels.
We take monthly bookkeeping off your plate and deliver you your financial statements by the 15th or 20th of each month.
You’ll have your Profit and Loss Statement, Balance Sheet, and Cash Flow Statement ready for analysis each month so you and your business partners can make better business decisions.
Interested in learning more? Schedule a call with our CEO, Nathan Hirsch.
And here’s some free resources:
- Monthly Finance Meeting Agenda
- 9 Steps to Master Your Ecommerce Bookkeeping Checklist
- The Ultimate Guide on Finding an Ecommerce Virtual Bookkeeping Service
- What Is a Profit and Loss Statement?
- How to Read & Interpret a Cash Flow Statement
- How to Read a Balance Sheet & Truly Understand It
Conclusion
Accuracy in each costs of good sold journal entry depending on your specific situation in crucial. It affects all your other numbers, which also affects tax reporting. To avoid all kinds of trouble from incorrect profitability assumptions to IRS penalties, make sure your records are clean.
