If you are in business, you have heard of the terminology cost of goods sold. But what exactly is it?

In a product based business, cost of goods sold is the inventory you have sold to your customers. Before inventory is sold, the cost sits on the balance sheet as “merchandise inventory” and when sold, it moves to the profit and loss statement as “cost of goods sold”.

In a service business, your cost of services is what it cost you to directly service your customers. Since services are usually consumed as they are provided, there is no inventory in most true service businesses.

Here is how it works:

  1. When a merchandise business buys products for resale it is an inventory asset.
  2. When a merchandise business sells the product, it becomes cost of goods sold

Effectively predicting cost of goods sold

Inventory is the number one consumer of cash on the balance sheet. So effectively predicting your cost, is an essential part of cash management. A rise in cost of goods sold cause’s margins to diminish.  Rightly predicting cost of goods sold starts with accurately predicting sales. Once sales have been predicted, then we use sales numbers to effectively predict what our inventory level should be (i.e. quantity).

However, predicting the cost of the goods you sell is not as easy. Because besides knowing your sales level, there are other factors that affect the final cost.  This is what this article will focus on.

Inventory/ cost of goods sold cost is split into 3 parts

There are 3 components to inventory cost:

  1. Direct materials
  2. Direct Labor
  3. Product overhead

The total cost of your goods sold will be tied in to the cost of these individual components. Click on each hyperlink to see details of each component. Each of these components have many factors that affect their estimation while developing your budget. Once you have learned about each component, click here to see how they all tie together.

Next:  Predicting Direct Materials