How to Calculate Cost of Goods Sold
Cost of goods sold (COGS) is an important part of accounting that applies directly to tax deductions for your business.
- Cost of goods sold (COGS) expresses how much businesses had to invest in inventory they ultimately sold throughout a certain period.
- COGS helps businesses understand a portion of their expenses but does not include overhead expenses like marketing budget.
- Businesses can also deduct COGS from their taxes, so it is important to track expenses closely.
- This article is for businesses that want to better understand accounting and financial principles like COGS and cash flow.
Cost of goods sold (COGS) is calculated by taking the value of inventory at the beginning of the period being studied, adding the cost of any new inventory purchased over the covered period, and subtracting the value of inventory held at the end of the period.
COGS = Beginning Inventory + Purchases – Ending Inventory
The cost of goods sold (COGS) is used to calculate the company’s direct cost to purchase or produce each product sold within a specific time period. This is crucial since it significantly affects a company’s profitability over a specific time frame.
What is cost of goods sold (COGS)?
The direct cost of inventory sold by a corporation during a specific time period is known as the cost of goods sold. It comprises all expenses that are specifically related to the products or services that were sold within a specific week, month, or year. However, it does not include any overhead or fixed expenses; it just accounts for the cost of buying or producing merchandise that is sold within a specific time frame.
Formula for COGS
Although the cost of items sold focuses on cost, it is determined indirectly. COGS is computed by comparing the costs of beginning and ending inventory, adding the cost of inventory purchased and sold over the covered period, rather than adding up expenses to get the cost of goods sold directly. In other words, the model prioritizes the timeline over costs.
Beginning inventory less purchases and ending inventory equals COGS.
Of course, if you’re performing your own production, the COGS calculation also becomes a little more complicated. In that situation, the cost to produce the inventory would equal the starting inventory.
The direct cost of producing more over the time period would be represented by purchases, and the direct cost of unsold items would be represented by ending inventory.
Consider a retail establishment that opens the new year with a specific amount of inventory. The business owners spent $30,000 to buy the stock, which has a retail worth of $60,000.
Let’s imagine the business owners spend an extra $100,000 on inventory over the course of the next year, for a total retail value of $225,000. Additionally, the shop has leftover merchandise at the end of the year that is worth $40,000 and cost $20,000 to purchase.
The proprietors of the shop may use COGS to figure out their entire cost of inventory sold during the year, which is a crucial figure in figuring out their overall profitability for the year.
COGS = $30,000 + $100,000 – $20,000 = $110,000
In this case, the total cost of goods sold for the year would be $110,000. The store’s gross margin for the period (the gross sales for the year minus COGS) would be equal to $135,000 ($60,000 + $225,000 – $40,000 – $110,000).
Importance of COGS in accounting
In accounting, a firm, division, or product line’s profitability must be assessed in relation to its cost of goods sold. It’s a crucial statistic for businesses monitoring the direct expenses of their commercial inventories. It makes it simpler for managers to locate cost-cutting strategies, such as means of reducing inventory expenses.
Tracking COGS helps companies improve their inventory ordering (lowering ordering costs), measure inventory turnover, and lower inventory holding costs. This reduces wholesale expenses.
What does COGS tell you?
For business owners and managers, COGS indicates the entire direct expenses of their goods or services sold during a specific time frame. This enables businesses to compute their gross profit margin on sales generated during a specific time period, which is a step toward figuring out their net profit.
While COGS is a crucial indicator of a firm’s direct costs, it says nothing to managers about indirect costs, which include office supplies, back-office staff pay, corporate overhead, and marketing expenses.
Inventory accounting methods and COGS
Although there is only one formula for estimating the cost of products sold, businesses can select from a variety of accounting techniques to get their precise cost. Each approach has a unique technique of determining how much a certain item sold for within a specific time period cost.
There are at least four accounting techniques that are often used to calculate COGS. Any of these are acceptable choices for businesses, but once they make a decision, they must stick to it. It can be challenging for businesses to decide, but the choice they make might have a big influence on their profitability and tax implications.
But, regardless of which method you choose, the best accounting software solutions makes it easy to use COGS in your business accounting. Some software can even help you decide on a method by showing which is most advantageous for you.
First in first out (FIFO) is an accounting principle that holds that anytime a business makes a transaction, the inventory that has been on hand the longest will be the first to be sold. Therefore, when a firm makes a transaction, COGS per unit is stated to be $5 per unit until all of its year-old units are sold. This is because if a company paid $5 per unit a year ago and it pays $10 per unit currently.
While FIFO might be advantageous for some organizations (making it simpler for businesses to manage inventory turnover, for example), it can also result in larger tax obligations if a company’s inventory costs are steadily rising.
According to the last in, first out (LIFO) strategy, the inventory of a business’s most recent purchases is what has sold first. As a result, until all of a firm’s more recent acquired units have been sold, COGS per unit is considered to be $10 if a company paid $5 per unit a year ago and it pays $10 per unit currently.
LIFO can provide firms with considerable tax benefits, particularly those that keep sizable and expensive inventory. However, if a business significantly reduces its inventory in a given time and sells some of its “cheapest” inventory—and prices have increased since the inventory was acquired—this might result in disproportionately high tax payments for a specific year.
The cost of each individual unit is not taken into account when using the average approach to determine COGS. It makes no difference what was bought when or how an organization’s inventory expenses change. Instead, organizations that employ the averaging technique construct an average cost per unit, multiply that average by the quantity of units sold over a specific time period, and use that result to calculate COGS.
Because it provides a contented middle ground between the FIFO and LIFO approaches, the average method is significant. Although it’s not the best approach in terms of taxes, it’s also not the worst. It is also rather simple to utilize regularly and put into practice.
An accounting technique called the specific identification method enables businesses to give exact values to each unit sold over a given time frame. This approach might be perfect for companies that provide customized products or services or those that have inventory with a broad range in value, like an antique store.
Without the unique ID technique, the cost of goods sold (COGS) for companies like these would vary greatly depending on what they sell over a given time period. The particular identification approach can greatly increase the predictability of their tax burden while assisting them in precisely totaling their COGS for a certain time frame.
COGS vs Expenses
Even though cost of goods sold is an expense for a corporation, it only represents the direct costs of the items or services a firm sold within a specific time. However, indirect costs like overhead, utilities, and marketing expenses are not included in COGS.
A company’s gross margin is determined, then subtracted from its gross sales to get it. The net earnings of the company are then determined after deducting other costs. In order to offer a company’s owners and management the most complete view of the business’s finances, COGS are often accounted for separately from other costs (where feasible) despite the fact that they are expenses.
Limitations of COGS
Although COGS may be very beneficial for organizations to track their direct expenses and find cost-cutting opportunities, it also has several drawbacks. Due to the fact that it excludes expenses like marketing, COGS do not accurately reflect a company’s total cost of sales. Additionally, COGS do not reflect a company’s profitability accurately since it excludes fixed costs.
Additional COGS drawbacks include:
- True COGS can vary widely per unit sold
- COGS fluctuates based on the volume of sales in each product line
- COGS may fluctuate across periods, even when sales are level, depending on the accounting method a company uses
- Managers need to be very attentive to understand their COGS
- The impact of COGS on a company’s profitability isn’t always immediately clear
Therefore, even while COGS is a crucial indicator, it does not accurately represent a company’s entire cost of doing business. Additionally, although though it’s frequently mentioned first on a firm’s income or cash flow statement, there are other expenses that must be covered whether or not a company generates revenue.