Understanding the cost of goods sold (COGS) is vital for businesses. It’s a key component of decisions regarding inventory, pricing, and more, but what exactly is it? This article outlines what COGS is, how to calculate it, and other crucial information you need to know.
What is Cost of Goods Sold?
Cost of Goods Sold (COGS) is a critical financial metric for businesses. It directly reflects the cost of producing the goods or services a company sells.
Here is an expanded explanation:
- Definition: COGS refers to the direct costs associated with producing goods that a company sells. This includes the cost of materials and direct labor involved in its production. For a retailer or distributor, COGS is typically the amount paid for the merchandise sold during the period.
- Importance in Pricing and Inventory Levels: By understanding the cost to produce each unit sold, businesses can accurately price their goods to ensure they’re profitable. COGS also helps in maintaining optimal inventory levels. By tracking the costs associated with each product, businesses can decide which items to stock more or less of based on their profitability.
- Role in Determining Gross Margin: Gross margin is the revenue a company makes after deducting the COGS from its total revenue. It’s a key profitability metric that investors and analysts use to compare a company’s efficiency with its competitors.
- Relevance in Financial Performance: Knowing what COGS is and how to calculate it accurately over a specific accounting period gives businesses a better understanding of their overall financial performance. If COGS is increasing, it might indicate a need to look for cheaper suppliers or improve operational efficiencies. If it’s decreasing, the business could be becoming more efficient or might be using cheaper materials.
- Inclusion in Income Statements: COGS is typically reported in a company’s income statement. It’s deducted from the company’s gross revenue to determine its gross profit.
To sum up, COGS is an important aspect of financial reporting and operational efficiency. It directly impacts a company’s bottom line and overall financial health. Thus, businesses must accurately calculate and closely monitor their COGS.
Direct Costs Vs Indirect Costs
Direct costs and indirect costs are two fundamental types of expenses that businesses encounter. They serve different purposes and are accounted for in different ways in financial reporting. Let’s delve deeper:
Direct Costs
- Definition: A direct cost is an expense that a business can specifically attribute to the manufacturing or production of goods or services. They are often variable costs, changing based on the level of production.
- Examples: Materials used in production and direct labor (wages for the employees who directly contribute to the production of goods) are common examples of direct costs. For instance, in a car manufacturing company, the cost of steel and wages for assembly line workers would be considered direct costs.
- Tracking and Accounting: Direct costs can be accurately traced and assigned to the production of specific goods or services. In financial statements, they are often included as part of the Cost of Goods Sold (COGS).
Indirect Costs
- Definition: Indirect costs are the overhead expenses that are not directly tied to the production of a specific good or service. These costs are generally fixed and are incurred irrespective of the level of production.
- Examples: Rent, utilities, administrative salaries, and advertising costs are examples of indirect costs. For instance, in the same car manufacturing company, the electricity bills for the office building and the salary of the CEO would be considered indirect costs.
- Tracking and Accounting: Because they cannot be directly linked to any one product, indirect costs are distributed across all units produced. These costs often show up on the income statement under operating expenses.
Understanding the difference between direct and indirect costs is crucial for businesses as it allows them to:
- Calculate Gross Profit: Gross profit is calculated by subtracting direct costs (COGS) from revenue.
- Determine Overhead Rate: Overhead rate, which is used to apply indirect costs to products, is determined based on total indirect costs.
- Price Products Accurately: By understanding both direct and indirect costs, businesses can accurately price their products to ensure profitability.
- Manage Costs: Recognizing which costs are direct and which are indirect can help a business identify areas where costs can be managed more effectively.
What COGS Includes
COGS is an important concept in accounting firms and finance and includes four major components – direct materials, direct labor, manufacturing overhead, and selling expenses. Let’s take a look at each of these components in more detail.
Direct Materials
Direct materials are the raw materials used to make a product. They can include items such as lumber for furniture, leather for shoes, or fabric for clothing. The fixed costs associated with these items are considered part of the cost of goods sold.
Direct Labor
Direct labor refers to the time and resources needed to manufacture a product. This may include direct labor costs like employee wages or commissions, payroll taxes, and other benefits associated with employees working on the product.
Manufacturing Overhead
Manufacturing overhead refers to general costs associated with running a business such as equipment repairs and maintenance, plant rent, or utilities used during production. These costs are also included in the cost of goods sold calculation.
Selling Expenses
Selling expenses refer to advertising and selling activities associated with selling a product. This includes things like marketing campaigns, transportation costs related to selling the product, and any commissions paid to sales representatives or agents who help with sales efforts.
What Cost Of Goods Sold Does NOT Include
COGS does not include the four major components of research and development costs, general and administrative expenses, non-manufacturing overhead, and income taxes. Let’s look at each of these components in more detail.
Research And Development Costs
Research and development costs refer to the costs associated with researching new products or processes. These costs are not included in the COGS calculation since they do not directly relate to the production of a product.
General And Administrative Expenses
General and administrative expenses are those related to running a business such as office rent or professional services such as legal fees or accounting services. These expenses are considered separate from COGS.
Non-Manufacturing Overhead
Non-manufacturing overhead refers to expenses associated with running a business that do not directly relate to production activities, such as marketing campaigns or travel expenses for sales representatives. These costs are excluded from the cost of goods sold calculation.
Income Taxes
Income taxes are expense items that are excluded from the COGS calculation since they have already been factored into gross profit when calculating net income.
How to Calculate Cost of Goods Sold
COGS can provide a deeper understanding of the business’s profitability as well as help to identify areas where cost control can be improved upon. It can be calculated easily by following these steps:
Calculate the opening inventory
To calculate the opening inventory, simply add up the cost of any goods that were in stock at the start of your chosen period.
Add up total purchases
The total purchases are all the costs associated with buying goods during your chosen period, such as purchase price, freight costs, and other related expenses.
Subtract closing inventory
The closing inventory refers to any goods still in stock at the end of your chosen period. You need to subtract this number from your opening inventory and total purchases to get your COGS figure.
Cost of Goods Sold Formula
Cost Of Goods Sold = Opening Inventory + Purchases – Closing Inventory
What is a Cost of Goods Sold Example?
COGS is an important metric to help business owners assess the profitability of their operations. To understand this concept better, let’s look at a simple COGS example.
- A small business starts the fiscal year with 500 units of inventory at a cost of $4.50 each, for a total beginning inventory of $2,250.
- During the fiscal year, they purchase 1,500 additional units at a cost of $5 each, for a total purchase expenditure of $7,500.
- At the end of the fiscal year, their remaining inventory is 400 units at a cost of $5 each, bringing their total closing inventory to $2,000.
- Using the formula above we can calculate that the Cost Of Goods Sold (COGS) during this period is: COGS = $2,250 + $7,500 – $2,000 = $7,750
Pros of COGS
COGS has many advantages that make it the ideal choice for many businesses. Here are five of the biggest pros of COGS:
- Easier Inventory Management: Tracking COGS helps businesses keep a better inventory of the goods they have in stock, as well as how much they cost. This makes it easier to adjust production and sales numbers accordingly.
- Accurate Financial Planning: Calculating cost of goods sold allows companies to plan their finances more accurately by taking into account the costs associated with purchasing materials, producing goods, and selling them.
- Better Cash Flow Management: Keeping track of COGS helps companies manage their cash flow more effectively by providing a clear picture of how much money is being spent on inventory costs, production costs, and sales expenses.
- Reduced Risk of Losses: Knowing exactly how much money is going into purchasing materials, producing goods, and selling them gives companies a better idea of what potential losses could be in different scenarios. This can help businesses reduce risk and make better strategic decisions.
- More Efficient Internal Control System: Tracking COGS provides companies with greater internal control over their operations by allowing them to monitor expenditures closely and make sure that the costs associated with producing and selling goods remain within acceptable levels.
Cons of COGS
While COGS offer many advantages to businesses, there are a few potential drawbacks. Here are three of the cons of using COGS:
- Complexity: Setting up and maintaining a system for tracking costs can be complex and time-consuming.
- High Initial Setup Costs: There can be a significant upfront investment in both hardware and software that is needed to track costs with COGS.
- Disconnect from Actual Performance: As COGS track operational costs only, they do not provide an indicator of overall performance or customer satisfaction.
| Pros of COGS | Cons of COGS |
|---|---|
| Easier Inventory Management: Tracking COGS helps businesses keep a better inventory of the goods they have in stock, as well as how much they cost. This makes it easier to adjust production and sales numbers accordingly. | Complexity: Setting up and maintaining a system for tracking costs can be complex and time-consuming. |
| Accurate Financial Planning: Calculating cost of goods sold allows companies to plan their finances more accurately by taking into account the costs associated with purchasing materials, producing goods, and selling them. | High Initial Setup Costs: There can be a significant upfront investment in both hardware and software that is needed to track costs with COGS. |
| Better Cash Flow Management: Keeping track of COGS helps companies manage their cash flow more effectively by providing a clear picture of how much money is being spent on inventory costs, production costs, and sales expenses. | Disconnect from Actual Performance: As COGS track operational costs only, they do not provide an indicator of overall performance or customer satisfaction. |
| Reduced Risk of Losses: Knowing exactly how much money is going into purchasing materials, producing goods, and selling them gives companies a better idea of what potential losses could be in different scenarios. This can help businesses reduce risk and make better strategic decisions. | |
| More Efficient Internal Control System: Tracking COGS provides companies with greater internal control over their operations by allowing them to monitor expenditures closely and make sure that the costs associated with producing and selling goods remain within acceptable levels. |
Cost of Goods Sold Accounting Methods
COGS accounting methods refer to the various ways in which businesses can account for their costs. Here are five different accounting methods to consider:
Operating Expenses vs. COGS
Operating expenses are those costs related to running a business, such as salaries and rent, while COGS refer only to the costs incurred in producing goods or services that are sold directly to customers.
FIFO
FIFO stands for First In, First Out, and is an accounting method whereby inventory items purchased first are assumed to be sold first. This method is most accurate when pricing products remains relatively stable over time.
Special Identification
The Special Identification method is used when it’s important to track the sale of a specific item or group of items from the inventory. This approach allows businesses to record the exact prices at which each item was sold.
Average Cost
Average Cost assigns an average cost per unit based on all the purchases made during a given period of time. It simplifies accounting for relatively low-cost items and makes calculating sales revenue easier.
LIFO
LIFO stands for Last In, First Out, and assumes that inventories purchased last should be recorded as being sold first. This approach can be beneficial under certain circumstances but it can also create discrepancies between actual profits and taxes owed due to inflation.
| Method | Description | Pros | Cons |
|---|---|---|---|
| Operating Expenses | Costs related to running a business, such as salaries and rent. | Provides a full view of the operational expenses required to run the business. | Does not specifically consider the costs associated directly with producing the goods or services sold. |
| COGS | Costs incurred in producing goods or services that are sold directly to customers. | Provides a clear view of the costs directly associated with producing the goods or services sold. | May not provide a full picture of the costs to run the business overall. |
| FIFO (First In, First Out) | An accounting method whereby inventory items purchased first are assumed to be sold first. | Most accurate when pricing products remains relatively stable over time. | Can overstate profit if prices are rising because it assumes cheaper older inventory is being sold first. |
| Special Identification | Used when it’s important to track the sale of a specific item or group of items from the inventory. | Allows businesses to record the exact prices at which each item was sold. | It is labor-intensive and more complex than other methods. |
| Average Cost | Assigns an average cost per unit based on all the purchases made during a given period of time. | Simplifies accounting for relatively low-cost items and makes calculating sales revenue easier. | May not accurately reflect cost of items if there are wide price fluctuations within the period. |
| LIFO (Last In, First Out) | Assumes that inventories purchased last should be recorded as being sold first. | Can reduce income taxes in periods of inflation because it assumes more expensive newer inventory is being sold first. | It can create discrepancies between actual profits and taxes owed due to inflation, and may not accurately reflect physical flow of inventory. |
Final Words
Understanding what COGS is and how to calculate it can be an essential part of being a successful business owner.
Having an understanding of the basics of a balance sheet, cost accounting, tax brackets, and payroll compliance, as well as business abbreviations and acronyms is also vital for companies to be able to create a business budget that will help make them more profitable.
Understanding how to hire a business accountant, avoid common accounting mistakes, ways of increasing your profit margin with available tax deductions, and ensure accuracy in your calculations is important as well.
With the right level of knowledge about COGS and other related topics, you will be able to make sure that your business runs smoothly.
Is cost of goods sold an expense?
Yes, cost of goods sold is an expense. It refers to the costs associated with products or services that have been sold to customers. This includes direct production costs such as raw materials as well as indirect costs such as labor and overhead costs related to manufacturing and distribution.
Is cost of goods sold an asset?
No, cost of goods sold is not an asset. It is an expense and is reported on the income statement as part of the cost of sales. COGS represents the cost of the inventory that has been sold during a period and thus reduces a company’s profits.
Is cost of goods sold a debit or credit?
Cost of goods sold is a debit in the accounting journal entries. It typically reduces the inventory account and increases the cost of goods sold expense account.
What is beginning inventory in relation to COGS?
Beginning inventory is the cost value of the merchandise or goods that a business had on hand at the beginning of a period. Beginning inventory is important to calculate COGS, as it must be subtracted from ending inventory to arrive at COGS.
What is cost of sales vs cost of goods sold?
Cost of sales and cost of goods sold (COGS) are both measures of the total cost associated with the production and sale of goods. Cost of sales is calculated by adding the beginning inventory to purchases, then subtracting the ending inventory. Cost of goods sold is calculated by subtracting the ending inventory from the beginning inventory.
Are Salaries Included in COGS?
Salaries are not typically included in COGS and only include the costs associated with all products or services sold by the business during a period, such as raw materials, labor for production, and freight charges.
How Does Inventory Affect COGS?
If a business has more inventory on hand, the COGS will be higher. Conversely, if there is less inventory available, the COGS will be lower. Changes in the prices of raw materials and labor can also affect the overall COGS.
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This article, “What is Cost of Goods Sold and How to Calculate It + Everything Else You Need to Know” was first published on Small Business Trends