Is this definition of COGS right or wrong?

[JetCityWoman]

I recently started a small online shop using one of the big platforms. I'm familiar with basic accounting, so do my own bookkeeping using QB Online, but I'm no accountant so definitely want to be educated if I'm doing something wrong.

In the blog for that platform software, someone wrote this definition of COGS (which I think is wrong):

Cost Of Goods Sold (COGS)

Cost of goods sold refers to expenses that are directly associated with your product. Most often, this either means products that are purchased wholesale, or raw materials that go into producing a product.

Many people—including bookkeepers—think that COGS is equal to the invoices received from vendors during the year. It is not.

When you purchase a product or material, you are exchanging money for inventory. It is only when you sell the item that you recognize its cost. This can have a drastic effect on your bottom line.

Let’s say you have no inventory to start with, but spend $150,000 buying inventory that you plan to sell for $300,000 (a 100% markup). If your only sell $100,000, your COGS will be $50,000. The remaining $100,000 in unsold product will be recorded as inventory.

If instead, you record the entire $150,000 as your COGS, your business will show a negative gross margin, and of course, no inventory. That's just not accurate.

Your accounting software will calculate your cost of goods sold for you, but here's the basic formula.

Opening Inventory + Purchases — Ending Inventory = COGS

Well first thing, either he's got a typo in there or his math is wrong, but let's set that aside for now. My question is about the formula. If this is true and accurate then when I record my wholesale purchases (that I later resell), what category should I use? I'm currently recording my wholesale purchases in a category called "Wholesale COGS", and later when I sell the product, I record it as income in a "sales" category. If I'm doing it wrong, how should I be recording those two events?

 

[DerrickWD]

I see no problem in what you quoted. Purchases are not cost of goods sold.

When you make a purchase, you record the purchase in inventory, when using a perpetual inventory system, at cost.

So say you bought goods for $300.
Dr inventory. 300
Cr Cash. 300

Later you sell half of these goods for $300. The entries are:

Dr. Cash. 300
Cr Sales. 300

Dr Cost of Goods Sold. 150
Cr Inventory. 150

 

[Fidget]

With COGS the clue is in the full title: Cost of Goods Sold. In other words, it's the direct costs of making the sale. The reason for it, in case you're interested, is that it goes back to one of the fundamental concepts of accounting - the accrual (or matching) concept. You have to match income & expenses in the same period that they relate to. So, when you recognise a sale (the income), you recognise the expenses directly associated with it at the same time.

The formula is fine as well, but, that's it at basic level and would be ok to apply to the likes of retailers that just buy in goods from 3rd parties and sell them again. For manufacturers/construction, the waters are muddied a bit because there's other stuff such as direct labour/subcontractor and work in progress to be included as well.

By the sounds of it, you're doing it right. I don't know QB by the way, but it sounds like you're recording your purchases as inventory and then as sales, and assuming QB's chart of accounts is correctly configured, then QB will do the work for you in calculating your cost of goods sold.

Something else, just in case you're not aware of it, is that you can add delivery costs (carriage in) and a few other expenses that may have been incurred to the cost of your purchases that you're holding in inventory. So it's not purely the cost of the item that you treat as inventory.

 

[JetCityWoman]

One of the commenters to the blog pointed out that the blogger was talking about accrual based accounting, and cash-basis is different. I'm using cash-basis accounting (because I'm very small). It sounds to me like the major difference here is that there I'm recording my bought goods directly into COGS, although it's very possible that QB is doing the correct debits and credits for me automatically. My P&L certainly looks okay, I think. It looks like this:

Income
Gross Receipts
Sales......................113.00
Total Income...........113.00

Cost of goods sold
Wholesale purchases ...... 2151.71
Total COGS ......................2151.71

Gross profit....................... -2056.51

At least this is what I expected to see. I bought 2151.71 in goods as startup inventory and have sold 113 in goods so far (open one month).

I looked at the Chart of Accounts again. Even if I go to add a new account, none of the choices for category type are "inventory", only COGS. It does have a "products and service" section where you can define all that stuff, but the "types" only give me a choice of service or non-inventory item. That's out of the box, so I don't know why they're excluding inventory. Seems a glaring omission. But "products and services" can only be used with invoices anyway (as best I can figure out), and I'm recording my sales simply as bank deposits (my shopping platform keeps track of my orders and customers, so I don't yet need to double-track it).

I guess my next question is if I'm setting myself up for problems later on when I'm bigger?