How to Calculate Cost of Goods Sold? Decode COGS Calculation

What Is the Cost of Goods Sold?

The cost of goods sold is defined as a direct expense, related to the goods manufacturing in a particular company. Its other name is Cost of Sales. It covers the material cost and labor cost which are highly related to retail products manufacturing. Indirect expenses such as sales force costs and distribution costs are never considered in it.

COGS offers insight into the profitability of business operations and also analyzes the company’s gross profit margin.

Important Aspects about COGS:

• The cost of goods sold (COGS) includes the overall goods production expenditure.
• The COGS value depends upon the accounting method chosen by the company.
• The profit margin is always low when the COGS value is high.
• Indirect costs like sales marketing and overhead are never included in COGS.

What Are the Costs COGS Includes?

The total production cost of goods is consistently accounted for by COGS. The products sold are done during a specific period. The cost factors considered are –

• Labor cost
• Material cost
• Indirect cost
• Shipping cost
• Direct production cost

Why Is the Cost of Goods Sold (COGS) So Crucial?

So many business owners like to know the answer to why the cost of goods sold is so valuable. Well, COGS is obtained by subtraction from the company’s revenue and leads to gross profit. So COGS is an important term on a business financial statement. Gross profit determines the company’s ability in labor and supplier management.

COGS is never proportional to net income. With the COGS increment, there will be a decline in net income. Due to this reason, many business owners try to keep the COGS limit low.

The following points justify the Cost of Goods Sold (COGS) value in the business.

Identify Profitability – COGS is favorable for a company to determine profit. Ultimately, the company gets a clear picture of which product is giving more profit and also sets an ideal cost for the benefit.

Inventory Optimization – By reducing COGS, it is possible to reduce storage costs. This ultimately helps with production enhancement, stock, and purchase.

Expenditure Tracking and Allocation – COGS is very vital for expenditure tracking and allocation. Business professionals can effortlessly identify the expenditure associated with product manufacturing. Meanwhile, it is easy to accomplish expenditure allocation with the correct COGS.

Taxation – Companies can easily manage and comply with tax regulations with the correct COGS calculation. The consideration of goods sold as deductible expenses in taxation is the major cause here.

Settlement of Price – COGS is functional in setting pricing strategies, and business owners can easily set a competitive price. If the COGS is high, then the price will be low.

What Are the Drawbacks of COGS?

COGS is prone to errors due to the complex calculation approach. A wrong COGS can lead to many issues in the overall business operation. An incorrectly calculated COGS can directly impact net income. So COGS should be calculated correctly. Otherwise, it will be a waste of time and hurt the process.

Cost of Goods Sold Formula

Plenty of business owners lack familiarity with the appropriate procedure of how to calculate the cost of goods sold. The following formula is highly beneficial in this case.

Cost of Goods Sold = Starting Inventory + Purchases – Ending Inventory

Now let’s understand this formula with one cost of goods sold example explained below. Imagine you run a company that records –

Inventory of $30,000 at the beginning of the year.

Inventory of $9,000 at year-end

Cost of purchase – $9,000

COGS = ($30,000 + $9,000) – $9,000

COGS = $30,000

So here, the Cost of Goods Sold is $30,000.

This example presents the correct solution to how to calculate COGS. Companies use this strategy to determine the final result.

Tips for COGS calculation

• Always know the direct costs and indirect costs for an efficient result.
• Indirect costs are never included in the calculation and are avoidable.
• Identify the beginning inventory.
• The beginning inventory of every year will be identical to the last year’s ending inventory if the business does annual COGS calculations.
• Always seek advice from accounting professionals in case of any doubt.
• Conduct a regular inventory audit.
• It is good practice to adopt accounting software.

Cost of Goods Sold Formula for Retailers

COGS is crucial for retailers to determine the direct cost of selling products. Therefore, they need to perform an accurate COGS calculation. In the case of retailers, the overall cost is directly associated with inventory.

Ending inventory, material cost, supply expenditure, freight, and sales tax are covered in COGS calculation. Retailers can have better inventory management, profit margin, and appropriate setting of product prices.

The formula for calculating COGS for retailers

Cost of Goods Sold = Beginning Inventory + Purchases – Ending Inventory

Here,

Beginning Inventory: The inventory value at the initial time of the accounting period.

Purchase: It is the total cost of inventory items bought during the particular accounting period.

Ending Inventory: The inventory value considered at the end of the accounting period.

Cost of Goods Sold Formula for Manufacturers

The cost of goods sold calculation is a bit complex for the manufacturer. In this scenario, manufacturing overhead, labor, and raw materials are covered by the COGS calculation. Manufacturers can easily optimize production costs and their overall financial performance.

The formula for calculating COGS for manufacturers

COGS = Beginning Inventory + Cost of Goods Manufactured – Ending Inventory

Here,

Beginning Inventory – An inventory value at the beginning of any accounting period.

Cost of Goods Manufactured – The goods producing cost covers labor, materials, and manufacturing overheads.
Ending Inventory – The inventory value at the year’s or accounting period ends.

Revenue Cost vs Cost of Goods Sold

The cost of revenue is always applicable for in-progress contract services. Direct labor, shipping costs, and commission amounts come under this category. That simply means it does not include any kind of product manufacturing.

However, certain companies sell products along with their services. The best examples are airlines and hotels because they offer food items and beverages along with services. So, they can use COGS as they utilize inventory.

The cost of goods sold always covers the products manufacturing cost, known as direct cost. Labor cost, production operation cost, and material cost are covered under it.

Operating Expenses vs Cost of Goods Sold

COGS is always used to determine direct expenses related to products manufacturing, and services. It comprises material costs, labor, and machinery maintenance. Calculating an accurate COGS is highly important because of its direct relation to profit margins. The lower the COGS, the higher will be the profit margin.

On the other hand, operating expenses (Opex) include indirect costs associated with day-to-day business operations. They are not directly linked to product manufacturing or goods selling but are vital for the overall function. Also, their role is vital to ensure a proper distribution of resources and capital allocation.

What Are the Different COGS Accounting Techniques?

There are four major methods of COGS accounting. The chosen costing method will decide the COGS value.

1. First in, First Out (FIFO)

First In First Out, known as FIFO in short, is a popular COGS accounting method. According to this, those products are sold first, which are produced first. FIFO is highly applicable to products that possess a short-term life or are perishables by nature.

2. Last In, First Out (LIFO)

Opposite to FIFO, Last in, First Out is about selling the products that were produced in the last. This leads to a higher COGS amount. LIFO is mostly applicable when product prices are high.

3. Weighted Average Cost

This is another COGS accounting method. The amount of money is identified by a weighted average. This amount goes into inventory and COGS. The stock product’s average price is utilized to value the goods sold. Large-scale manufacturing industries utilize this kind of method.

4. Special Identification Process

In this method, the ending inventory and COGS calculation is highly dependent on the specific cost of each unit of inventory or goods.The sold item is always under the knowledge of the business. Companies selling real estate projects, cars, and jewelry use this method.

Which Companies Do Not Consider COGS Deduction?

Some companies do not consider COGS dedication. Product-based companies like manufacturing units consider COGS, but purely service-based companies do not. These firms do not manage any inventory.

Law offices, accounting firms, real estate appraisers, and consulting firms are some companies in this category. They have a cost of service term that reflects the expenditure in providing service. However, this is not covered by the COGS deduction.

How to Control the Cost of Goods Sold?

Organizing COGS Category Wise

No doubt, there is a clear projection of the business growth while looking at COGS. But a detailed analysis is not possible. One can measure sales more specifically by considering COGS for the particular product. There is a need to run a well-organized structure.

Look For Deals With Suppliers

There are high chances of price negotiation when you make bulk purchases. Moreover, you can sign a long-term partnership or exclusive agreement. In this way, business owners can lower inventory costs.

Automation Integration

Adopting automation can cut down on the cost of goods sold. No doubt, purchasing a machine can be an expensive option, but it can lower the cost of goods sold. Incorporating AI is also helpful in determining the amount of product needed to manufacture.

Cut Down on Waste and Theft

There can be a huge difference between purchased inventory and inventory that is sold out due to waste and theft. Mind it sure, every piece of inventory goes into the final product that further goes to the customer. This is the way to control the cost of goods sold.

Verdict

So, we’re concluding our discussion on the calculation of the cost of goods sold. COGS decides the company’s growth because the lower the COGS, the higher the company’s profit margin. Business owners must manage their COGS efficiently. It will be highly profitable if they manage it and keep COGS under control.

Hope, you have a clear understanding of the cost of goods sold. Manage your every financial activity with Moon Invoice. The fantastic platform to create invoices, estimates, credit notes, and expenses.

FAQs