Choosing an Accounting Method for the Cost of Goods Sold Expense
8 of 11 in Series: The Essentials of Keeping Your Business Accounts
One main accounting decision companies that sell products must make is which method to use to record the cost of goods sold expense, which is the sum of the costs of the products sold to customers during the period. You deduct the cost of goods sold from sales revenue to determine gross margin. Cost of goods sold is a very important figure because if gross margin is wrong, bottom-line profit (net income) is wrong.
Product costs are entered in the inventory asset account in the order in which they're acquired, but they aren't necessarily taken out of the inventory asset account in the same order. You can choose between several methods to record your cost of goods sold and the cost balance that remains in your inventory asset account:
The FIFO (first-in, first-out) method: You charge out product costs to cost of goods sold expense in the chronological order in which you acquired the goods. The procedure is that simple. It’s like the first people in line to see a movie get in the theater first. The ticket-taker collects the tickets in the order in which they were bought.
The LIFO (last-in, first-out) method: The main feature of the LIFO method is that it selects the last item you purchased first, and then works backward until you have the total cost for the total number of units sold during the period.
The average cost method: Compared with the FIFO and LIFO methods, the average cost method seems to offer the best of both worlds. The costs of many things in the business world fluctuate, so you may decide to focus on the average product cost over a time period. Also, the averaging of product costs over a period of time has a desirable smoothing effect that prevents cost of goods sold from being overly dependent on wild swings of one or two acquisitions.