What Is the Cost of Goods Sold (COGS)? How Is COGS Calculated?

Evaluating financial performance is essential for any finance leader aiming to enhance efficiency and profitability within their organization. Analyzing the cost of goods sold (COGS) on financial statements is one method used to gauge financial health. COGS indicates the total direct costs involved in producing or acquiring the goods and services an organization sells over a financial period. This information helps CFOs and other decision-makers evaluate profitability, manage costs, analyze gross profit margins, and create precise budget forecasts.

This article explains the significance of COGS in business finance, details its calculation and reporting on the income statement, and offers strategies for reducing COGS.

What Is the Cost of Goods Sold?

The cost of Goods Sold, or COGS, is the calculation of direct costs incurred in the production of goods or services. It includes items bought for resale, raw materials, purchase returns and allowances, freight-in costs, trade or cash discounts, components used in production, factory labor, factory overhead expenses, and storage costs, and it varies in proportion to revenue.

As the revenue grows, the need for more resources to produce goods or services increases. COGS typically appears as the second line item on an income statement immediately following sales revenue. It is subtracted from revenue to calculate gross profit. COGS includes all costs necessary for producing or delivering the company’s services. These costs may involve variable expenses like raw materials and labor for manufactured goods.

Depending on accounting practices, fixed costs such as factory overhead, storage fees, and sometimes depreciation might also be included. Cost of goods sold excludes general selling expenses like management salaries and marketing costs. These expenses are listed below the gross profit line in the section for selling, general, and administrative (SG&A) expenses.

Calculating COGS determines the actual cost of merchandise sold during a specific period. COGS does not account for the cost of goods purchased but not sold or those that remain in inventory. This metric is crucial for management and investors to assess the performance of the business.

Significance of COGS

The COGS is a critical metric for managing a business effectively. It informs pricing strategies, supplier choices, and profit margin analysis. Additionally, the cost of goods sold offers insights into operational efficiency, influencing decisions about increasing wages, relocating for cost efficiency, or investing in updates and renovations.

Inaccurate COGS calculations can adversely affect your tax liabilities and limit your capacity to borrow, particularly when planning to expand your business. Here are key reasons why precise COGS calculation is crucial:

• Taxable Income: COGS is a deductible business expense that can significantly reduce taxable income. Companies often include as many eligible expenses as possible in their COGS calculations to decrease their tax obligations. Accurate record-keeping of manufacturing and inventory costs is essential to support these deductions.
• Helps You Calculate Gross Profit: Gross profit is calculated by subtracting COGS from total revenue. This figure indicates how well a company manages its production and labor costs. Since COGS directly affects gross profit, a higher COGS typically means lower net income, making it a vital focus for investors, managers, and analysts for estimating profitability.
• Pricing Decisions: Understanding the cost of goods sold helps businesses determine appropriate pricing by reflecting the true cost of business operations. Setting prices lower than COGS can lead to reduced profits or losses, emphasizing the importance of accurate cost assessment in pricing strategies.

How to Calculate COGS?

COGS primarily measures cost, yet it uses an indirect method for calculation. It doesn’t simply sum up inventory costs. Instead, it evaluates the difference between the costs of starting and ending inventory and includes the costs of goods both purchased and sold within the period. The formula is structured as follows:

COGS = Beginning Inventory + Purchases – Ending Inventory

This calculation grows more complicated for businesses involved in manufacturing. Here, ‘Beginning Inventory’ refers to the production costs of inventory at the start, ‘Purchases’ represent the costs incurred from manufacturing additional goods during the period, and ‘Ending Inventory’ reflects the production costs of goods that haven’t been sold by the end of the period.

Here are the key elements of the COGS:

• Identify Direct Costs

Direct costs are expenses explicitly linked to the production of goods or services. They encompass all the expenses incurred during the production, purchase, and sale of a product and are recorded under the COGS. For instance, direct costs in the production of t-shirts may include materials such as polyester, the operation of printing machines, and the ink needed for designs.

• Assess Indirect Costs

Often described as overhead or fixed costs, indirect costs do not significantly change with the level of production or sales. These costs include salaries of factory staff, rent, utility bills, and maintenance expenses for warehousing facilities, which do not vary with production volumes.

• Evaluate Facility Costs

These are the fixed expenses associated with production sites, including rent or mortgage payments on the property, interest expenses, and costs for maintaining manufacturing units and warehouses. These costs are critical for accountants to consider to ensure accurate profit margin calculations.

• Beginning Inventory

At the beginning of each financial year, companies determine their beginning inventory, which comprises unsold products, leftover materials, and partially finished goods from the previous year. This inventory is essential for calculating the next year’s COGS.

• Purchases

Initially, the inventory count only includes existing stock. As the year progresses, this inventory grows as the company produces and sells more products. Monitoring the costs associated with manufacturing and shipping each item is important. For in-house products, the accounting team needs to calculate the costs, which may fluctuate based on material usage, facility costs, and production time.

• Ending Inventory

At the start of a tax year, there is an initial inventory count which changes over the year. By the year’s end, the ending inventory includes all remaining products and materials, minus any items that are damaged or unsellable. The value of these unsellable items is deducted from the total inventory.

The final step involves calculating the COGS for the fiscal year. This calculation uses the values of the beginning inventory, any additions during the period, and the ending inventory. The COGS calculation includes only the direct costs, such as materials and labor, excluding indirect expenses like marketing and sales costs.

Different Methods for Calculating COGS

Businesses may use various methods to calculate their cost of goods sold, resulting in different COGS values. Understanding these methods is useful for anyone pursuing a career in accounting. The specific identification method is typically used for high-value or unique items. The three main costing methods are:

• First In, First Out (FIFO) Method

The FIFO method assumes that the goods purchased or produced are sold first. As prices usually rise over time, this method often results in the sale of less expensive products initially, leading to a lower COGS and, as a result, a higher net income over time.

• Last In, First Out (LIFO) Method

The LIFO method assumes that the most recently added goods are sold first. During periods of price increases, this leads to the sale of more expensive items first, which raises the COGS and likely results in a decrease in net income over time.

• Average Cost Method

This method calculates the COGS based on the average cost of all goods available, regardless of when they were purchased or manufactured. It helps even out price variations and ensures more consistent COGS over time by averaging the costs.

• Specific Identification Method

This method accurately assigns a specific cost to each merchandise unit to calculate each period’s ending inventory and COGS. Its accuracy is essential in industries that handle unique items, such as automobiles, real estate, and rare jewelry, as it allows companies to determine the exact cost associated with each item sold.

COGS Example

Consider a bookstore that begins the year with an inventory initially valued at $50,000 at retail, which costs $25,000 to purchase. Throughout the year, the bookstore buys additional books costing $80,000, which could be sold for a total of $180,000. By the year’s end, the remaining unsold books are valued at $30,000 in retail, with a purchase cost of $15,000.

To assess the bookstore’s cost of goods sold (COGS) and profitability for the year, the owners calculate COGS as follows:

COGS = $25,000 + $80,000 – $15,000 = $90,000

Therefore, the total COGS for the year is $90,000. The gross margin for the period, calculated as total sales minus COGS, would be $115,000 ($50,000 + $180,000 – $30,000 – $90,000).

How Is COGS Different from COS?

Some companies use COGS and Cost of Sales (COS) interchangeably on their balance sheets, which can lead to confusion about their differences. While both terms refer to the direct costs involved in producing a company’s goods and services, they are not identical:

• Scope of Costs: COS includes both direct and indirect costs associated with the sale of goods and services, whereas COGS strictly involves the direct costs of producing goods.
• Placement on the Income Statement: On the income statement, COS is listed before calculating the EBIT margin, which indicates operating earnings relative to operating sales. COGS is shown immediately after revenue, reflecting the direct costs incurred in generating that revenue.
• Magnitude of Costs: COS generally includes a wider array of costs compared to COGS, making it typically higher as it encompasses more than just direct production costs.
• Method of Calculation: The calculation for COS depends on the number of goods sold, while COGS is determined based on the number of goods manufactured.
• Tax Deduction: Unlike COS, which is not tax-deductible, COGS can be deducted from gross receipts to calculate a business’s annual gross profit. This deduction can increase a company’s tax deductions and reduce its reported profit.

How Is COGS Different from OpEx?

The key difference is that the cost of goods sold covers an organization’s direct production costs. Operating Expenses (OpEx) cover indirect costs such as selling, general, and administrative expenses essential for running daily business operations.

COGS encompasses an organization’s direct costs to acquire or produce the goods and services it sells, including expenses like labor and materials. Companies calculate COGS to assess profitability and adjust pricing strategies to cover overall costs.

On the other hand, OpEx includes indirect business costs that are not directly linked to producing goods but are necessary for generating revenue. These costs include marketing expenses, office supplies, rent, insurance, and employee salaries. Monitoring and managing OpEx helps businesses control day-to-day expenses that affect their profitability.

Essential Tips for Precise COGS Calculation

• Determining direct and indirect costs is vital when calculating your COGS. Direct costs include expenses directly associated with production, such as raw materials and labor on the production line. In contrast, indirect costs, which should not be included in COGS, cover salaries for employees not on the production line, office space rent, and depreciation of non-production assets.
• It’s important to monitor your beginning inventory accurately. Your inventory at the start of the year should be the same as the inventory at the end of the prior year, ensuring precise tracking of costs year over year.
• Returned goods also play a significant role in COGS calculations. To avoid overstating your revenue, it’s essential to accurately record all returns and allowances, subtracting these from your total sales. This adjustment ensures your COGS reflects only the goods that were actually sold.
• Your inventory valuation method (such as FIFO, LIFO, or Average Cost) influences your COGS calculations. Consistency in the chosen accounting method is key for reliable financial reporting and enables accurate comparison over different periods. Switching methods can cause substantial variations in COGS, impacting financial analysis and forecasting.
• Lastly, changes in supplier pricing can alter your COGS. Continually monitoring these changes is crucial for predicting their effects on your costs. This is especially important for businesses heavily reliant on raw materials. Making timely adjustments to your pricing strategy or sourcing decisions might be necessary to sustain profitability.

Conclusion

Understanding and accurately calculating the Cost of Goods Sold (COGS) is vital for any business aiming to enhance efficiency and profitability. COGS represents the total direct costs incurred in producing or acquiring the goods and services sold during a financial period. This metric informs key financial decisions, such as pricing strategies, supplier choices, and profit margin analysis.

Accurate COGS calculations also impact taxable income and borrowing capacity. Businesses can precisely assess their financial performance by including direct costs like raw materials and labor while excluding indirect expenses. Employing consistent inventory valuation methods and keeping detailed records are essential practices for maintaining accurate COGS and ensuring sound financial health.

Frequently Asked Questions