What Is Cost of Goods Sold (COGS) and How to Calculate It
Running a business involves lots of costs such as employee turnover, payroll taxes, maintenance costs, labor costs, production costs, permits and licenses, and more. Understanding your visible and hidden business costs is key to ensuring you can meet your financial goals.
If your business sells products, you must have a clear understanding of what the cost of goods sold (COGS) is all about. Cost of goods sold is one of the most essential accounting terms and small business bookkeeping basics that every business owner should know. The cost of goods sold plays a key role in setting the prices of goods.
Understanding COGS and how to manage its components can be the difference between running a profitable business and a not-so-profitable one.
In this article, we will cover the meaning of cost of goods sold (COGS), why you need to know your COGS, four inventory cost methods for cost of goods sold, the COGS formula and calculation examples, how to calculate COGS in six easy steps, and the limitations of COGS.
Let’s get started.
What is Cost of Goods Sold (COGS)?
Cost of Goods Sold (COGS) simply means the cost of producing the products or services you sell. It includes the cost of all direct materials or direct services used to attain the final product sold to consumers. COGS is the cost of purchasing and converting goods or services to the state of being sold.
The cost of products you do not sell is not a part of the Cost Of Goods Sold (COGS), neither are overhead costs. People make the mistake of adding overhead costs to the COGS.
Overhead costs are direct or indirect expenses necessary to run your business but are still not part of the COGS. Costs of things like utility bills, internal employee salaries, marketing costs, and transportation fares, among others are not part of the COGS but only overhead costs.
If you run a mattress-making company, the cost of the foam, sheets, and threads used to make a mattress are its COGS. The cost to market the product and transport it to your customer’s destination is not.
There is also a distinction between COGS and the cost of inventory. The cost of inventory only covers the cost of goods that are not yet sold but are ready to be sold. COGS covers the cost of goods that are already sold. Other names for the cost of goods (COGS) include “cost of sales” and “cost of services”.
The cost of goods sold (COGS) is also different from the cost of goods manufactured (COGM). COGM refers to all manufacturing costs the company incurs to turn inventory into a finished product such as direct labor, direct materials, factory overhead, and other manufacturing-related costs. COGS refers to production costs incurred on goods sold.
Why You Need to Know Your COGS
While running a business, you need to know your COGS. It is crucial for the determination of different elements that make up the financial aspect of your business. A few reasons for this include:
1. COGS Helps You Determine the Right Pricing
Pricing a product can be a difficult task. This is especially the case when you are a manufacturer of a product without a universal price.
Profits need to be made and are determined by the amount of money people pay for your goods. You do not want to set a price that is lower than the cost of producing the product. You most definitely are going to make a loss.
Knowing your COGS helps you determine the right price that gives you a healthy profit margin. You know when the price on a particular product needs to increase and even set competitively lower prices for you to attract more customers.
For example, when you determine that the COGS for a product is $100, then you understand that its price needs to be higher than $100 to generate a profit.
2. You Can Easily Determine Your Overall Profitability
Your gross profit is the amount your business earns from selling your products or services before subtracting taxes and subsequent expenses. Your net profit is the amount your business earns after subtracting all taxes and other expenses.
The formula for calculating your operating income is:
Net Operating Income = Revenue – COGS – Expenses
Knowing your business’s COGS is an integral part of calculating your overall business profits. Why do you need to know your overall business profits? You may ask.
Knowing your gross and net income helps you determine your profitability and financial performance. It helps you make smarter financial decisions and understand where you can improve upon.
Companies are given the idea of what the production costs are and can determine if they are too high or too low. Then, they can make adjustments to increase the overall profitability of running the business.
Inventory Cost Methods for Cost of Goods Sold
There are four inventory cost methods that determine the cost of goods sold (COGS). They are First-in-first-out (FIFO), Last-in-first-out (LIFO), weighted average, and special identification
1. First-in-first-out (FIFO)
In this type of inventory costing, the first items produced or purchased are sold first. This inventory cost method is easy to understand and generally accepted. When companies mention inventory management, the FIFO method is the first that comes to mind.
With FIFO, bookkeeping is easier with fewer chances of mistakes. The FIFO method is most especially crucial in the case of perishable goods where the first product to be produced has to be sold first. Less waste of inventory is recorded with it.
Even if the products are not perishable, the remaining products in the inventory will be a better reflection of the current market value. The products that are not sold are the most recently purchased or manufactured. You have a chance to set prices as the market changes.
Financial accounts are harder to manipulate with this method, and an accurate picture of the company's finances is given.
2. Last-in-first-out (LIFO)
The LIFO method of inventory costing is legal but mostly frowned upon because of its complex nature and its vulnerability to manipulation.
In this method, the last item to be produced or purchased is sold first. Your cost of goods sold (COGS) may be higher due to the possibility of the rising cost of goods or materials.
Unlike in the FIFO method, however, corporate taxes are lower for a company under the LIFO method. As LIFO allows you to use your most recent product costs first, where these costs have risen over time, the reduced recorded profit means tax breaks. It may also make your company less appealing to investors.
The value of the remaining inventory is also understated. The reason why is because you are going by the older costs in a currently inflated market. It can make the older inventory remain in the inventory forever.
3. Weighted Average
In this method, the average price of all the goods sold, regardless of their purchase or manufacturing date, is used as the price of the goods sold.
The weighted average method is commonly used when inventory items are so intermingled or identical that it becomes difficult to recognize and assign a specific cost to an individual unit. It prevents the COGS from being greatly impacted by extremely high or low costs of purchasing or manufacturing one or more items.
4. Specific identification
The special identification method uses the specific cost of each unit of inventory to determine the ending inventory cost and COGS for each period.
This method is used to specifically track particular items of inventory. It is applicable when individual items can be clearly identified with the use of a serial number, stamped receipt date, bar code, or RFID tag, among others.
Industries that deal with items like cars, real estate, and precious jewelry make use of the specific identification method.
Understanding the Cost of Goods Sold Formula
The formula for calculating the cost of goods sold for any product involves adding the cost of beginning inventory to the cost of purchased or manufactured (additional) inventory for an accounting period and then subtracting the cost of ending inventory from the total.
Here is the formula for calculating the cost of goods sold.
Cost of Good Sold = (Beginning Inventory + Additional Inventory) – Ending Inventory
There are three keywords in this formula you need to understand what they mean and represent to accurately calculate the cost of goods sold for your product. They are the beginning inventory, additional inventory, and ending inventory.
- Beginning inventory refers to the cost of inventory that a company has at the beginning of the accounting period. It includes the unsold raw materials and products from the previous period.
- Additional inventory refers to the cost of purchased or manufactured inventory that was purchased during the current accounting period. It includes the costs of direct materials, direct labor, and direct overheads, such as rent, warehouse expenses, and electricity tied directly to the production of the goods or services under consideration.
- Ending inventory refers to the cost of inventory that the company has at the end of the accounting period. It includes the products and raw materials that the company could not sell during the period.
The accounting period, which refers to the timeframe for calculating the cost of goods sold, may refer to monthly, quarterly, or annual periods.
Cost of goods sold (COGS) is also used to calculate other accounting formulas such as gross margin and inventory turnover.
Inventory turnover refers to the ratio that indicates the number of times a business sells and replaces its inventory. Gross margin refers to the difference between a business’s revenue and cost of goods sold,
Cost of Goods Sold Example Calculation
Cost of Goods Sold Calculation: Example 1
Let’s assume an online store uses the calendar year to record its inventory. It records the beginning inventory on the 1st of January and ending inventory on the 31st of December.
If the online store has a beginning inventory of $10,000 and buys products or raw materials for $5,000 during the accounting period. On the 31st of December, it is left with an ending inventory of $3,000. What is the cost of goods sold?
Cost of Good Sold = (Beginning Inventory + Additional Inventory) – Ending Inventory
Cost of Good Sold = ($10,000 + $5,000) – $3,000
Cost of Goods Sold = $15,000 – $3,000
Cost of Goods Sold = $12,000
The cost of goods sold for the calendar year is $12,000.
Cost of Goods Sold Calculation: Example 2
Let’s assume another online store hosted on the eCommerce platform Shopify sells fine jewelry. If the online store has a beginning inventory of $200,000 and buys products or raw materials for $100,000 during the accounting period. At the end of the accounting period, it is left with an ending inventory of $20,000. What is the cost of goods sold?
Cost of Good Sold = (Beginning Inventory + Additional Inventory) – Ending Inventory
Cost of Good Sold = ($200,000 + $100,000) – $20,000
Cost of Goods Sold = $300,000 – $20,000
Cost of Goods Sold = $280,000
The cost of goods sold is $280,000.
How to Calculate COGS in 6 Steps
Step 1: Determine Direct and Indirect Costs
Calculating the goods sold (COGS) starts from determining your product or service’s direct and indirect costs. There are two types of cost included in COGS: direct cost and indirect cost.
Direct costs refer to all costs that relate directly to the production or purchase of the product. Examples of direct costs include direct labor, direct materials, and manufacturing supplies. Direct costs can be fixed or variable. Knowing your direct costs plays a crucial role in determining the price of your product or service.
Indirect costs refer to all costs that contribute to the production or purchase of the product indirectly such as warehousing, rent, utilities, indirect labor, equipment, general office expenses, professional expenses, and other overhead costs. They can either be fixed such as rent or variable such as utilities.
Step 2: Determine Facilities Costs
The next step is to determine your facilities’ costs. Facilities costs refer to the cost for buildings and other locations that your business uses. They are difficult to determine.
You need the expertise of an accountant to accurately calculate this cost. It is mandatory for you to set a percentage of your facility costs (rent, utilities, mortgage interest, and other costs) to each product for the accounting period under consideration.
The accounting period is usually for a year and is done for tax purposes.
Step 3: Determine the Beginning Inventory
Inventory consists of the products you have in stock, raw materials, supplies, work in progress, and finished products. You need to account for every item in your inventory.
There are two ways you can do this, either counting everything in inventory physically or use inventory management software to automate the inventory management. Examples of inventory management software include QuickBooks Inventory Management, NetSuite, and Zoho Inventory.
The beginning inventory refers to the inventory you have at the start of the accounting period. It should be the same as your ending inventory for the last account period. If your beginning and ending inventory do not match, you need to submit an explanation for the difference on your tax form.
Step 4: Add Purchases of Inventory Items
The majority of businesses add their inventory during the year. It is essential for your business to keep track of the total shipment cost and manufacturing cost for the products you add to inventory. Keep the invoices and other paperwork for purchased products.
Step 5: Determine the Ending Inventory
Ending inventory costs refers to what is left of your inventory at the end of the accounting period. It is usually determined by estimating or taking a physical inventory of products.
Your ending inventory costs can be reduced for worthless, damaged, or obsolete inventory. For a worthless inventory, you have to provide evidence that the inventory was destroyed, while for damaged inventory, you have to report its estimated value. For an obsolete inventory, provide evidence of the decrease in inventory value.
Step 6: Do the COGS Calculation
The last step is to do the COGS calculation. You have all the information you need to do this.
Limitations of COGS
The major limitation to COGS is that accounting is not always accurate. Either by mistake or on purpose, accountants or managers can easily alter the COGS in different ways. Some of these include:
- Allocating higher manufacturing overhead costs to inventory than those incurred
- Overstating discounts on goods
- Overstating returns to suppliers
- Modifying the amount of inventory in stock at the end of an accounting period
- Overvaluing inventory in stock
- Failing to write-off abandoned pr obsolete inventory
All these reasons lead to an inflated valuation of the whole inventory and COGS. The effects of purposely inflating or deflating the value of inventory are cynical in most cases.
When values are inflated, COGS will be inaccurate and gross profit is recorded to be higher than it actually is, which leads to an inflated net income.
Inflating the COGS is usually done to fool Investors or possible loanees about the whole value and performance of the business or company. Nonetheless, investors can spot unethical inventory accounting by looking through a company’s financial statements closely.
One thing that can indicate such acts is inventory rising relatively faster than revenue or total assets reported. Understating the cost of inventory is usually done to reduce the amount of income tax paid out.
Cost of Goods Sold FAQ
COGS only applies to those costs directly related to producing goods intended for sale. This amount includes the cost of the materials and labor directly used to create the goods. It does not include indirect costs such as overhead, marketing, salaries, cost of labor, and other administrative expenses.
However, there are types of labor costs that can be included in COGS, as long as they can be retracted from specific sales. For example, the salary paid to industry experts to increase revenue or seasonal hires can be included in the cost of goods sold because they increased revenue. Other expenses included in the cost of goods sold are cost materials purchased and delivery costs.
To be able to balance your account, you need to calculate the COGS on the debit side. The expenses incurred during production, purchase, processing, and delivery of a sold product are all calculated as debit activities.
Since all of the expenses just mentioned fall under the cost of goods sold, COGS is regarded as a debit entry on the balance sheet.
When the cost of goods sold is subtracted from sales, the remainder is the company's gross profit. If your COGS ends up being higher than gross profit, a loss has been incurred on items of inventory sold.
No, operating expenses are expenses companies undertake during normal operations to keep the business up and running.
Operational costs are the opposite of COGS, they are expenditures that are not directly tied to the production of goods or services. It may include overhead costs like rent, fixed cost of machinery, maintenance costs, salaries of regular workers, and office supplies.
No, only Inventory that has been sold can appear in the balance sheet under the COGS account. The cost of items not sold is not calculated, rather these items are moved into the next inventory beginning.
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