“Hi, I am a small business that provides clients with computer repair services; do I need to include cost of goods sold on my income statement?” I know it sounds obvious but, can be tricky for starters and non-accountants. I fact, people still asks—in the forums, blogs and social media ponds—whether or not a services company includes cost of goods sold, since long time ago. So, I would like to address the question through this post.
Does Accounting Standard Rule Cost of Goods Sold Presentation?
Addressing accounting issues, whatever they are, first thing you want to do is seeking answer on the accounting standard (US/Local-GAAP or IFRS.) Unfortunately, you won’t find any procedures for cost of goods sold, on the standard. Why?
Because the standard rules Financial Accounting only—it does not address management nor cost accounting issues. And cost of goods sold is fallen under the Cost Accounting area.
IAS 1 requires an entity to, at minimum, present “cost of sales” (= another expression for “cost of goods sold”) on its income statement, separated from the operation expenses, without any further details about:
- how cost of goods sold should be presented;
- what items should be included on the category;
- how it is calculated; and
- whether or not a service company has to present cost of goods sold
That said, cost of goods sold presentation, in detail, is under the management discretion. It makes sense since Cost of Goods Sold, in detail, is more often used for internal rather than external analyses.
What is Cost of Goods Sold, How Is It Determined?
“Cost of Goods Sold is the cost of the inventory items sold during the period.” (IAS 1)
In the case of a merchandising company, COGS is computed this way:
Inventory Beginning Balance = xxx
Plus: Net purchases = xxx
Cost of Goods Available for Sale = xxx
Minus: Inventory Ending Balance = (xxx)
Cost of Goods Sold = xxx
Net Purchase = purchases + freight-in – less discounts – returns – allowances
Determination of COGS in a manufacturing company is little bit different: to arrive at cost of goods available for sale, “Cost of Goods Manufactured” is added to the beginning inventory balance. And to arrive at cost of goods sold, the ending finished goods inventory balance is then deducted from the cost of goods available. Here how COGS, in manufacturing businesses, is calculated:
FG inventory beginning balance = xxx
Plus: Cost of goods manufactured = xxx
Cost of goods available for sale = xxx
Minus: FG inventory ending balance = (xxx)
Cost of goods sold = xxx
While “Cost of Goods Manufactured” is calculated as follows:
Beginning direct materials inventory balance = xxx
Net purchases of materials = xxx
Total direct materials available for manufacturing = xxx
Direct materials inventory ending balance = (xxx)
Direct materials used = xxx
Direct labor = xxx
Depreciation of factory equipment = xxx
Utilities = xxx
Indirect factory labor = xxx
Indirect materials = xxx
Other overhead items = xxx
Factory overhead = xxx
Manufacturing cost incurred = xxx
Plus: Work in process beginning balance = xxx
Minus: Work in process ending balance = (xxx)
Cost of goods manufactured = xxx
But those are for merchandising and manufacturing companies. What is it in the case of a services company? Read on…
Common Misconception: a Services Company Has No Inventory
I often find misconception suggesting that, any services company definitely has no inventory. That is true in the case of a company ‘purely’ sell services but, how many businesses, today, does stay a live by selling services only? Not many.
- A computer repairer is a good example. Is it a services business? Yes but, it sells its clients computer spare parts and peripherals, occasionally, in addition to the computer repair services. So it has inventory.
- An airline company is another good example. Airline companies sell air transportation services as their main business but, they also sell merchandises such as: gift and souvenir items—in wide range of selection—to their passengers. So airline companies also have inventory.
- Next is hotel. Hotels sell accommodation services (room and its facilities) but, they also sell foods, beverages, to snacks (in the mini-bar unit installed on each room). So a hotel is a services company but usually has inventory.
Therefore, assuming services companies have no inventory, without having a look at their revenue sources, is premature and could lead to mistakes. For a services company that sells merchandises, in addition to services, cost of good sold should be included on its income statement.
“How about a services business ‘purely’ sells services (no merchandise at all)?” You may ask.
Incase if you haven’t heard about it yet, let me introduce you with “Cost of Services” or “Cost of Revenue” that can be seen as the “cost of goods sold” of companies sell pure services.
Cost of Services (Cost of Revenue) for Services Business
A pure services business—such as accounting firms, law firms, business appraisers and the like—of course, does not accumulate cost of goods sold, since they don’t sell goods but, it accumulates typical costs to proceed and deliver services to the clients.
The costs incurred to deliver services to the clients, in a services company, are accumulated and included in a group of costs called “Cost of Services.” In the case of such costs that are in an ongoing contract services (e.g. a contractor that implement completion contract method,) it is called “Cost of Revenue”.
What expenditures are included in the cost of services?
Here are expenses, commonly included in the cost of services:
- Sales commissions
- Wages for part timer or freelancers that work to deliver the services
- Fees for professionals paid by projects
- Transportation cost to deliver the services
- Rental cost for equipment and tools that occurs only when services is sold
Depending on type services sold, expenditures included to the cost of services vary from a services company to another. A good way to determine whether or not an expense should be included in the ‘cost of services’, is by asking yourself one of the following questions:
“Does this expense occur ONLY when services are sold?” If the answer is “YES,” you would then include the expense in the cost of services, and vice versa.
“Does this expense up-and-down as the sales up-and-down too?” If the answer is “YES,” include the expense in the cost of services, and vice-versa.
Cost of good sold, according to IAS 1, is the cost of the inventory items sold during the period.
The accounting standard (IAS 1) requires that an entity should, at minimum, present “cost of sales” on its income statement, separated from the operation expenses. However, it does not address cost of goods sold in detail—thus is on the management discretion, as long as it helps the financial statement’s users with reliable and relevant information.
In the case of a services business that sells merchandises, in addition to services, it would need to present cost of goods sold on its income statement. But in the case of a services business that sells services only, it would present Cost of Services or Cost of Revenues, instead.[/box]