Cost of sales debit or credit?
Cost of sales, also known as cost of goods sold (COGS) is a calculation of all the direct costs incurred on the production of the goods produced and sold within a certain period of time. The cost of sales in accounting doesn’t include indirect costs like sales expenses and distribution. Therefore, as the number of finished products increases or decreases, the cost of sales figure would vary because it only includes the costs for the goods sold during the period. It doesn’t include the cost of the finished goods that are not yet sold.
In financial reports, the cost of sales is treated as an expense account. Expenses have a natural debit balance and as such, the cost of sales will be a debit entry in a double-entry bookkeeping system. In this article, we will discuss the cost of sales as a debit and not a credit entry. But first, let’s look at what the cost of sales is in accounting.
Related: What type of account is the cost of goods sold?
What is the cost of sales?
The cost of sales measures the ability of a firm to design, source, and manufacture goods at a reasonable cost. This makes it a key part of the performance metrics of a firm as well as an important metric on financial statements. It is the cost of manufacturing or acquiring the goods and products that a firm sells during a period.
For example, the cost of sales for an automaker would include the material costs for the parts that are used in the making of the car plus the costs of labor used to put the car together. This means that the cost of sending the cars to dealers and the cost of the labor used to sell the car would not be included in the cost of sales calculation. The term cost of sales is more likely to be used by manufacturers.
Also, the costs that are incurred on the cars that are not sold during the year will not be included in the cost of sales calculation, regardless of whether the costs are direct or indirect. Therefore, the cost of sales only includes the direct cost of producing goods or services that were purchased by customers during the year.
The cost of sales is subtracted from the revenue of a company to determine its gross profit. This gross profit as a profitability measure evaluates how efficiently a company is managing its supplies and labor in the production process. Since the cost of sales is the cost of doing business, it is recorded on the income statement as a business expense.
An expense account records a decrease in the owners’ equity that occurs from the use of assets or records an increase in liabilities incurred from delivering goods or services to customers. Companies organize the various expenses of their business over a certain duration of time into expense accounts with sub-accounts like the cost of goods sold or cost of sales, rent expenses, payable interest, wages expenses, repairs and maintenance, insurance rates, utilities, salary expenses, and bank charges/fees, etc. This enables whoever is reading the financial statement of a company to clearly see where money is going.
The cost of sales entry records the total of all direct costs that are incurred during the production of sold goods. It is the direct costs incurred on the production of goods manufactured and then sold. Therefore, it only includes the directly associated costs of inventory and labor. Hence, knowing the cost of sales helps investors, managers, and analysts estimate the company’s bottom line (net income).
If the company’s cost of sales increases, the company’s net income will decrease. Even though this is beneficial for income tax purposes, the disadvantage of a decrease in net income is that the business will have less profit for its shareholders. Due to this, businesses try as much as possible to keep their cost of sales low so that net profits will be higher.
How is the cost of sales calculated?
That is, the journal entry for cost of sales is a calculation of the beginning inventory plus purchases, minus ending inventory. The essence of cost accounting is to track the expenses that are involved in manufacturing or selling a product or service. Depending on the product sold, the cost tracking and inventory systems would vary. As seen in the cost of sales formula above, inventory happens to be an essential part of the cost of goods sold calculation. The beginning inventory figure in the cost of sales formula can be drawn from existing records while the ending inventory sometimes requires a physical count.
Let’s look at an example to understand how the cost of sales is calculated. Take, for instance, a company that has $10,000 of inventory on hand at the beginning of the month. Then, during the month the company expends $25,000 on various items and at the end of the month has $8,000 of inventory on hand. This is how the cost of sales will be calculated:
Using the cost of sales formula: Beginning inventory + Purchases – Ending Inventory
Cost of sales = $10,000 beginning inventory + $25,000 purchases – $8,000 ending inventory
= $10,000 + $25,000 – $8,000
= $27,000 cost of sales
As seen from the cost of sales calculation, the cost of sales does not include any general and administrative expenses or any costs of the sales and marketing department. After calculation, the cost of sales is listed as a line item that appears near the top of the income statement, as a subtraction from net sales. The result of this calculation is the gross margin earned by the reporting company.
Now, that we have an understanding of what the cost of sales is; is the cost of sales debit or credit? Let’s look at what the debit and credit entry means in accounting to understand the correct entry for cost of sales in the double-entry bookkeeping system.
See also: Is Sales Discount Debit or Credit?
The double-entry bookkeeping system
In accounting, transactions are usually recorded either as a debit or credit entry. That is, for every transaction recorded in business, an amount must be recorded in one account as a credit entry and the same amount must be recorded in another account as a debit entry. This system of accounting is known as a double-entry bookkeeping system (T- accounts). It tends to provide accuracy in accounting records and financial statements.
Accountants make use of debit and credit entries to record each business transaction. They make use of the balancing double-entry bookkeeping system to generate financial statements. Every business transaction will affect at least two accounts which are entered either as a debit in one account or as a credit in another account. In the T-account, the debits are on the left-hand side of the ledger and the credits are on the right-hand side of the ledger.
For instance, when recording a $900 cost of sales in the books, two accounts will be affected. A debit entry of $900 will be made to an expense account called the cost of sales account and a credit entry of the same $900 will be made to an asset account called inventory which is reduced as the sale occurs. This debit and credit entry balances the transaction.
According to Pacioli’s double-entry bookkeeping system, in a balance sheet or ledger, the assets have to equal liabilities plus shareholders’ equity. That is, their total has to balance and this balancing effect is reflected in the balance sheet equation that is expressed as:
Assets = Liabilities + Owners Equity
Assets, usually have a debit balance and are shown on the left side of the balance sheet. Liability accounts and owners’ equity accounts, on the other hand typically have a credit balance and are shown on the right side. This means that, when an asset is increased, the change is a debit entry. whereas, an increase in liabilities will be a credit entry.
Debits either increase an asset or expense account and decreases an equity or liability account. Credits, on the other hand, increase equity or liability accounts and decreases an asset or expense account. That is, some accounts increase with a debit entry such as assets, expenses, losses and dividends while some decrease with a debit entry such as liabilities, equity, revenue, and gains. Conversely, some accounts would increase with a credit entry such as liabilities, equity, revenue, and gains while others decrease with a credit entry such as assets, expenses, losses and dividends.
Recall that, the cost of sales which is our main focus happens to be an expense account. Therefore, according to the preceding findings, the cost of sales as an expense would increase with a debit entry and decrease with a credit entry. Since it increases with a debit entry, does this confirm that the cost of sale has a natural debit balance and not a credit balance? Let’s discuss this further.
In accounting, all accounts that have a natural debit balance will increase in amount when a debit entry is added to them and will decrease in amount when a credit entry is added to them. This means that since assets, expenses, and dividends are the kinds of accounts that increase with debit and decrease with credit, they will have a natural debit balance. This confirms that the cost of sales has a natural debit balance and not a credit balance.
Conversely, all accounts that have a natural credit balance will increase in amount when a credit entry is added to them and will decrease in amount when a debit entry is added to them. This means that since revenues, liabilities, and equity is the kinds of accounts that increase with credit and decrease with debit, they will have a natural credit balance.
In addition, it is important to note that all accounts can be debited or credited depending on the kind of transaction that takes place.
See also: Is Accumulated Depreciation Debit or Credit?
Is cost of sales debit or credit?
The cost of sales is an expense account on the income statement and as such will increase by debit and decrease by credit. The inventory and purchases are asset accounts and therefore will also increase by debits and decrease by credits. However, when making a journal entry, the cost of sales would be debited and purchases and inventory accounts would be credited. This simply shows that the assets have been sold and their costs have been moved to the cost of sales account.
Therefore, one account (cost of sales) is debited, and one or more other accounts (purchases and inventory accounts) are credited to balance the entry. The credits to purchases and inventory must equal the debit to the cost of sale. Hence, the journal entry for the cost of sales would equal purchases plus inventory.
If a company is using the periodic inventory system, the costs of purchased goods are initially stored in the purchases account. This is normally a debit to the purchases account and a credit to the accounts payable account. Then, at the end of the reporting period, the balance in the purchases account is shifted over to the inventory account with a debit to the inventory account and a credit to the purchases account.
Lastly, the resulting book balance in the inventory account is then compared to the actual ending inventory amount. The difference is written off to the cost of sales with a debit to the cost of sales account and a credit to the inventory account. This simple accounting system for the cost of sales works well in smaller organizations.
Why the cost of sales is a debit and not a credit entry
Recall that, credit entries serve to increase revenue, liability, or equity accounts while decreasing asset or expense accounts while, debit entries serve to increase assets or expense accounts while reducing revenue, liability, or equity accounts. Since expenses cause a decrease in the owner’s equity, it is a debit entry and as such cost of sales as an expense account will have to be a debit entry.
The debit balances in the expense account at the end of the accounting year are usually closed and transferred to the owner’s capital account or transferred to Retained Earnings, which is a stockholders’ equity account (at a corporation), thereby reducing the equity account.
Related: Sales Debit or Credit?
Is cost of sales debit or credit in trial balance?
All the debit balances on a trial balance worksheet form the left column, and all of the credit balances form the right column. The debit balances include the expense and assets accounts while the credit side records the income and capital balances. Ideally, the total debit balance of a Trial Balance must equal the total credit balance. Therefore, it requires that an accurate record of all transactions is properly documented.
The trial balance aims to ensure that a company’s total debit entries balance the credit entries. Since the cost of sales involves certain business expenses, it is needed in drafting the trial balance. The expenses involved in purchasing, producing, processing, and delivering a good that has been sold are all debit activities. And the income that is generated from the sales is a credit. This is where the cost of sales or cost of goods sold becomes important. In order to be able to balance the account, the cost of sales will be calculated on the debit side. This means that cost of sales is a debit and not a credit in the trial balance.
Related: Cash sales debit or credit?
Cost of sales debit or credit?- Examples
A balancing transaction entry is known as a journal entry. These transactions as well as journal entries are summarized in a Trial Balance, and then a General Ledger. Let’s look at some examples of how to record the cost of sales in a journal entry. The examples below, show how the cost of sales has a natural debit balance and not a credit balance.
Example 1
Let’s say Company XYZ has a beginning balance of about $5,000 in its inventory account. Then, Company XYZ purchases $1,600 worth of material during the accounting period. Assuming at the end of this accounting period, the company counts $2,000 worth of ending inventory. What will be the cost of sales and the journal entry for it?
Solution
Calculating the cost of sales using the formula:
Cost of sales = Beginning inventory + Purchases during the period – Ending inventory
= $5,000 Beginning inventory + $1,600 Purchases during the period – $2,000 Ending inventory
Cost of sales = $8,600
The $8,600 Cost of sales entry would be entered as follows:
| Date | Account | Notes | Debit | Credit |
|---|---|---|---|---|
| 01/01/2022 | Cost of sales Expense | Materials purchased | $8,600 | |
| Purchases | $1,600 | |||
| Inventory | $7,000 |
As seen in the journal entry above, the Cost of Sales Expense account is debited by $8,600, and $1,600 is credited to the Purchases account. Then the inventory account is credited with $7,000 ($8,600 Cost of Sales – $1,600 purchase). Notice that, the respective $1,600 & $7,000 credits to purchases and inventory equal the $8,600 debit to cost of sale. Hence, balancing the transaction entry.
Example 2
A firm has a beginning balance in its inventory asset account of about $2,000,000. Assume, during the month, the firm buys materials from suppliers worth $450,000, which it records in the inventory account. Then, at the end of the month, the ending inventory is counted and it is confirmed that there is $575,000 of inventory on hand. What will be the cost of sales and the journal entry for it?
Solution
Calculating the cost of sales using the formula:
Cost of sales = Beginning inventory + Purchases during the period – Ending inventory
= $2,000,000 Beginning inventory + $450,000 Purchases during the period – $575,000 Ending inventory
= $2,000,000 + $450,000 – $575,000
Cost of sales = $1,875,000
The $1,875,000 Cost of sales entry would be entered as follows:
| Date | Account | Notes | Debit | Credit |
|---|---|---|---|---|
| 01/01/2022 | Cost of sales Expense | Materials purchased | $1,875,000 | |
| Purchases | $450,000 | |||
| Inventory | $1,425,000 |
As seen in the journal entry above, the Cost of Sales Expense account is debited by $1,875,000, and $450,000 is credited to the Purchases account. The inventory account is then credited with $1,425,000 ($1,875,000 Cost of Sales – $450,000 purchase).
Related: Common stock: debit or credit?
