A simple formula explains how goods and their costs flow through a business. Retailers purchase products from other companies and then sell those products in stores, online, or through catalogs to their customers. For example, Wal-Mart and almost every mall store are considered retailers.
Products flow through a retailer in the following order:
The supplier ships purchased products to the retailer.
The retailer displays the products so that customers can see them.
The customer buys and takes the product home.
Product costs flow through a retailer’s books just as the products themselves flow through the retailer’s operations. When the retailer purchases products, it owes the cost of those products to the supplier. Then when the retailer sells the products to its customers, it records both sales and cost of goods sold. Cost of goods sold then appears on the income statement as an expense.
Manufacturers go through basically the same process as retailers, except with a few more-involved steps necessary to actually make the products:
Note how manufacturers make goods:
Manufacturers purchase raw materials.
Manufacturers pay for labor and overhead to work on those raw materials. After they go into production, raw materials become work-in-process inventory.
When completed, work-in-process inventory becomes finished goods.
Just as with a retailer, when the goods are sold, they go to the customer.
At the same time as the goods themselves flow through a manufacturer’s operations, the cost of those goods flows through to the manufacturer’s books.
Direct materials are the physical materials needed to make products. They’re “direct” in the sense that you can easily trace direct materials to individual products. For example, suppose your factory produces doodads. Each doodad requires assembling one widget with one gizmo and one doohickey. Each of these parts, which you purchase from outside suppliers, is a direct material.
The terms direct materials and raw materials aren’t exactly interchangeable. Direct materials are the cost of raw materials that can be easily traced directly to the actual products made. Raw materials, therefore, may include both direct materials and indirect materials, materials that you can’t easily trace directly to individual products. Indirect materials are included in overhead.
The company and its supplier usually negotiate and set the price of buying direct materials. However, the overall cost of direct materials may also include charges for shipping direct materials to your place of business (if, say, your gizmo supplier is in China and your plant is in the United States) and any costs of storing and maintaining the direct materials.
Work-in-process inventory involves materials that have gone into production but haven’t yet been finished. The assembly process for doodads described in the figure usually takes a single employee eight hours to complete. The work-in-process inventory for this process is the stock of incomplete doodads — items the employee has started assembling but hasn’t yet finished.
After factory workers complete the work-in-process, it graduates to become finished goods inventory. Finished goods are completed products that are ready for sale. The cost of all completed factory output, known as cost of goods manufactured, includes all the costs associated with the products: direct materials, direct labor, and overhead.
Cost of goods sold
When a retailer or manufacturer sells goods, those goods become an expense called cost of goods sold. Cost of goods sold includes all the direct materials, direct labor, and overhead associated with the items sold during the year; it’s usually the largest expense on a manufacturer’s or retailer’s income statement.
Don’t confuse cost of goods sold with cost of goods manufactured. Cost of goods sold is measured as the cost of goods that were actually sold during the period regardless of when they were completed. It goes onto the income statement. Cost of goods manufactured is measured as the cost of goods that were actually completed during a period regardless of whether they were sold.