The two main benefits of setting up a business are to solve customers’ needs and make a profit. In as much as business owners seek to create products or offer services that provide innovative solutions to their customer’s problems, they also want to make money while doing that.
Running a successful business requires that you effectively put in measures to help the company reduce costs, and expenses and maximize profit.
Before you begin looking for ways to maximize your company’s gross profit, you need to understand the cost of producing your products or creating services and how to calculate it
Cost of goods sold (COGS) is one of the most essential accounting terms for business leaders and managers to know and take very seriously. It offers businesses the opportunity to run a business profitably.
In this article, we will discuss everything you should know about COGS and how you can calculate the cost of goods sold.
Table of Contents
- What is the Cost of Goods sold (COGS)?
- What is included in the cost of goods sold?
- Cost of Goods sold (COGS) vs Operating expenses
- Cost of Goods sold (COGS) vs. the cost of revenue
- Importance of calculating cost of goods sold
- Formulas and calculations of the cost of goods sold
- The accounting methods for the Cost of Goods Sold
- Limitations of cost of goods sold
What is COGS?
The cost of goods sold (COGS) also known as cost of sales is the total expense or total cost of producing a product that has been sold.
In simple terms, it refers to the direct cost of manufacturing goods sold by a company. Since revenue means the total sales of a company’s product or services, and the cost of goods sold is the accumulated cost of creating the products or goods.
COGS is an accounting term defined under the United States Generally Accepted Accounting Principles (GAAP) directing product-inclined companies to apply inventory costing principles. The GAAP provides guidelines for companies to determine which costs to include in the COGS and the formula to calculate the cost of goods sold.
Calculating COGs helps you determine two critical business metrics – the business’s gross profit and its gross margin. You can calculate the gross profit by subtracting the COGS from the while the gross margin is gotten by dividing gross profit by revenue.
Essentially, the higher a company’s COGS is, the lower its gross profit. Hence it’s important to calculate the cost of goods sold. COGS is reported right beneath the revenue line on a company’s income statement.
What is included in the cost of goods sold?
Cost of goods sold (COGS) is the direct costs that a company incurred while creating the goods sold.
It is divided into two different types of costs – the variable costs incurred include the cost of raw materials used and labor costs while the fixed costs include rents, factory overhead costs, etc.
To determine whether a cost should be included in COGS, you need to conduct a good litmus test to ascertain its eligibility. experts recommend asking yourself:
Would the cost exist if no products were produced? If the answer is no, then the cost is likely included in COGS.
Examples of costs generally considered COGS include:
- Raw materials
- Items purchased for resale
- Freight-in costs
- Purchase returns and allowances
- Trade or cash discounts
- Factory labor
- Parts used in production
- Storage costs
- Factory overhead
Cost of Goods Sold (COGS) vs Operating Expenses
Operating expenses is a term that’s quite popular among business and accounting professionals. Although it entails business-related costs, it is the opposite of the cost of goods sold.
Operating expenses or otherwise known as OPEX refers to the cost incurred by a company during normal business operations to keep the business up and running. Rather than the cost of producing a product, operating expenses are the cost of operating a business.
Opex includes selling, general and administrative expenses (SG&A) such as accounting, insurance, legal fees, travel costs, taxes, etc. It doesn’t take into account COGS and non-operating expenses such as interest and currency exchange costs.
Examples of costs generally accepted as operating expenses include:
- Salaries and wages (other than direct labor)
- Office Supplies
Cost of Goods Sold (COGS) vs. the Cost of Revenue
The cost of revenue is mostly used by service businesses, although it is also used by some manufacturers and retailers too.
Despite its similarity to the cost of goods sold, the cost of revenue is rather expansive. It includes not only the cost of goods sold but also the direct cost of sales-related expenses such as sales commissions, sales discounts, or the cost of distribution and marketing. Check out the difference between net sales and gross sales.
Unlike the cost of goods sold, the cost of revenue excludes all indirect costs that are not incurred as a result of sales.
Examples of costs generally accepted as the cost of revenue include:
- Direct marketing
- Online or online advertising
- Subscription cost
- Technologies operations
- Transportation/delivery/shipping costs
- Warranty and money back guarantee
- Customer service or support costs.
Importance of calculating cost of goods sold
When you calculate cost of goods sold, you gain valuable business insights that can help you achieve the following:
Setting the right price for your products
By calculating the cost of goods sold (COGS), you are able to set the right price for your products, in a way that can help you gain profits.
When you set a good product price, you can cover costs incurred from production while giving you a healthy gross profit margin.
Understanding your cost of goods sold (COGS) will provide you with the right information needed to decide whether you need to increase or decrease your prices.
Experts recommend also considering your target market and audience with COGS to determine your product price.
Understanding the financial health of your company
Calculating the cost of goods sold gives you an idea of the overall financial health of your company. This information can help you make better decisions on investments – whether you need to invest more in your operations or improve the way you manage your inventory.
COGS also helps you figure out your company’s financial capacity to pay back debts, if you cut down on payroll costs, or if it’s best for you to shut down your business operations.
Effectively managing your taxes
Considering the cost of goods sold (COGS) is a business expense, it can be deducted from taxes.
Tax evasion is a serious crime that can ruin the survival of businesses, hence it’s important to calculate the cost of goods sold to understand how to effectively manage your taxes and save you from legal troubles.
If your cost of goods sold (COGS) is high, you are more likely to pay lower taxes as a result of your low net income. Although high COGS is good for tax purposes, it doesn’t tell well about your business’s financial health – as it indicates that you are not making enough profit.
You will have to find a healthy balance to improve your business efficiency and profitability.
Identifying future opportunities for growth
Constantly calculating your cost of goods sold (COGS) can help you keep track of historical changes and seasonal trends that can affect the success of your business.
In order to understand how these changes and trends affect your business with the exact impact, you need to calculate COGS to analyze these trends and prepare accordingly for them in the future.
Experts recommend creating a cash flow forecast to identify growth opportunities that your business can leverage for success. Explore, what is sales opportunities.
Increase the efficiency of your products
When you calculate your cost of goods sold (COGS) regularly, you get a clear picture of your product performance, all that you can use to improve the efficiency of your product production.
By breaking down your product data and costs, you can identify ways to save money on each product and make a profit. Aside from understanding ways to save costs, you can also discover ways to make your product production process more faster and efficient.
Formulas and calculations of the cost of goods sold
Calculating the cost of goods sold is a pretty straightforward process. Use the following COGS formula to calculate your cost of goods sold.
COGS (Cost of goods sold) Formula = Beginning Inventory + Purchases During the Period – Ending Inventory
The breakdown of the formula (with inventory cost) is as follows:
- Beginning inventory is the amount of inventory left over from the previous period (e.g., month, quarter, etc.)
- Purchases during the period: is the cost of what you purchased during the accounting period
- Ending inventory is the amount of inventory you did not sell during the accounting period.
From the information contained above, you can decide on the timeline to calculate your COGS
The following steps can help business managers dive deeper into the COGS formula. They include:
- Identify the beginning inventory of raw materials, then work on process and finished products based on the previous year ending inventory amounts.
- Determine the cost of purchasing raw materials that were used at the time, with more focus on freight in, trade and discount.
- Determine the ending inventory balance – usually based on physical cycle counts and the company’s choice of inventory valuation methods.
- Make sure that every other direct production cost is included in the valuation of inventory.
Information needed to calculate the Cost of Goods sold
It is important to track the following data to accurately calculate your COGS:
1. Direct and Indirect costs refer to all the costs related to the production or purchase of a product and all costs related to warehousing, equipment, and labor. Calculating your COGS helps you deduct those costs from the product you sell.
2. Determine facilities cost: It is important to include the cost of your facilities when calculating your COGS. You must set a percentage of your facility cost (rent, mortgage, utilities, and other costs) for each of your products for the specific accounting period.
3. Determine beginning inventory: Your inventory includes all products in stock, raw materials, products in line for production, finished products, and supplies that are part of the items you sell. Your beginning inventory for the year should be the same as the ending inventory of the previous year. You must consistently count everything in your inventory to determine an accurate amount.
4. Include purchases of inventory items: Research suggests that growing businesses add new inventory throughout the year. For this reason, you must keep track of every new inventory coming into your business and store all slips and invoices for every shipment delivered to your business.
5. Determine your ending inventory by taking a physical inventory of the products and materials that remain at the end of the financial period. Ending inventory can be affected by ruined, low-quality products, hence you must report the estimated value of any damaged product and provide proof of how the product was damaged.
The accounting methods for the Cost of Goods Sold
GAAP has different methods of creating different inventory values that can significantly impact COGS and profitability. The three most commonly used methods for valuing inventory under GAAP include:
First in First Out (FIFO)
This method is an order of production approach that states that the oldest inventory is sold first. This suggests that the most recently produced inventory is those at the end of an accounting period. In situations when costs of raw materials or labor are increasing, the FIFO method yields a higher-per-unit valuation of inventory, hence causing COGS to be lower.
Last in First Out (LIFO)
This method is a reverse-production approach that states that the ending inventory at hand is the oldest units of products and the newest units have been sold.
In situations when costs of raw materials or labor are increasing, the FIFO method yields a lower-per-unit valuation of inventory, hence causing COGS to be higher. Check out the difference between FIFO vs LIFO.
Average Cost Method
This method values inventory using the average cost for the period. It combines costs from the entire period and considers price fluctuations. This method divides total costs to create products by the total units created over the entire period.
Limitations of cost of goods sold
The cost of hood sold can be altered by managers and accountants in the following ways:
- Overstating discounts.
- Overstating returns to suppliers.
- Overestimating or altering the inventory at hand.
- Not taking out outdated inventory
- Altering the manufacturing overhead cost.
Any of the above situations can alter the true cost of goods sold and not help you get the financial health of your company.
Cost of goods sold directly impacts your company’s profits as COGS is subtracted from revenue. Companies must manage their COGS to ensure higher profits and run a successful business. By calculating your COGS, you can effectively track your company’s costs and secure better deals with their suppliers or improve the efficiency of your product production process.