Cost of Goods Sold (COGS) refers to the direct costs of producing the goods a company sells. In calculating COGS, include only direct costs like materials and labor and exclude all indirect costs.
As an important metric in ascertaining gross profit, COGS tells the story of your company’s financial health.
You must understand COGS’s relationship with your profit margin and taxes to run your business well and even thrive.
In this post, you will learn COGS, how to calculate it, to leverage it for your business.
Get Custom Solutions
| Table of Content |
What is the Cost of Goods Sold (COGS)?
COGS means the direct costs of acquiring or producing the product a business sells. Therefore, in determining COGS, we exclude the business’s overhead costs.
There is some ambiguity concerning the nature of COGS on the balance sheet. On the one hand, COGS can be considered an asset as it brings revenue to the enterprise. On the other, it eats into the profit margin. In practice, it is simpler to classify it as an expense on the income statement.
The precise components of COGS vary with the type of business, but they fall into three broad categories – direct materials, direct labor and direct overheads.
Specifically direct costs include:
- Manufacturing supplies
- Direct labor
- Direct materials
- Freight
- Costs of power to operate production equipment
Here are examples of indirect costs excluded from calculating the cost of goods sold:
- Marketing costs
- Distribution costs
- Rent
- Utilities
- Administrative consumables
- Legal costs
- Sales and marketing
Cost of Goods Sold (COGS) Formula
Here is the formula for calculating the Cost of Goods Sold (COGS):
COGS = Beginning Inventory + Purchases – Ending Inventory
Where
- Beginning Inventory is inventory carried over from the previous accounting period
- Purchases are inventory acquired during the present accounting period
- Ending Inventory is inventory unsold by the end of the accounting period. Ending Inventory forms the Beginning Inventory for the next accounting period.
Note that the cost for the inventory consists only of costs directly associated with the making of the product. Determining direct and indirect costs is not always easy, and you must find a way of telling them apart.
How to Calculate COGS
Ideally, your COGS should be calculated by an accountant, as accuracy significantly impacts your tax liability and ability to plan for the future. Nonetheless, you can still learn the essentials of calculating the Cost of Goods Sold yourself.
This procedure lays out how to calculate COGS:
Determine Direct and Direct Costs
The easiest way to tell direct and indirect costs apart is how they vary with the output level. If the cost under consideration changes with the quantity of output, then it is a direct cost. If the price stays the same as output changes, it is indirect.
Direct costs include raw materials, packaging, distribution, and wages for labor directly involved in production.
Indirect costs include the cost of utilities like lighting, equipment costs, administrative salaries, and marketing.
Determine the Beginning Inventory
In an ongoing business, the Beginning Inventory usually is the Ending Inventory in the previous accounting period.
You can ascertain Beginning Inventory by using the formula
This year’s Beginning Inventory = Last year’s COGS + Last year’s Ending Inventory – Last year’s Purchases
The Beginning Inventory is typically nill (0) if the business is newly established.
Determine Purchases
Purchases depend on the nature of your business. For wholesalers and retailers, purchases refer to the inventory acquired within the accounting period. For manufacturers, purchases may mean the goods produced during the accounting period.
Calculate Ending Inventory
Ending Inventory is the inventory left over at the end of the accounting period. Usually, it is carried over to the next accounting period to form the Beginning Inventory.
However, it may be disposed of at a lower, zero, or negative margin by selling, giving to charity, or disposing of as waste.
You ascertain the Ending Inventory by subtracting inventory that has been sold from Beginning Inventory plus purchases.
Apply the COGS Formula
Once you have ascertained all the values, apply them to the formula to find the Cost of Goods Sold during that accounting period. You can also ask for help from us.
Example of how to calculate COGS
Jane Doe sells travel bags online. At the end of 2021, her Beginning Inventory had a value of $ 6000. In 2022 her purchases had a value of $ 30 000. If she closed the year with an inventory of $ 4500, what was the Cost of Goods Sold?
COGS = Beginning Inventory ( $6000) + Purchases ($30 000) – Ending Inventory ($4500)
COGS = $6000+$30 000-$4500 = $31 500
COGS and Inventory Accounting Methods
1. FIFO
FIFO (First In, First Out) is a way of costing inventory valuation assumes that the oldest inventory is disposed of first. Therefore whatever inventory is left is the newest.
In calculating the Cost of Goods Sold using FIFO, you first expense at the Beginning Inventory value and move upwards in the order of purchases.
For example, assume your Beginning Inventory is 100 units at $5, and you made purchases of 200 units at $7. If you sold 150 units under FIFO, you would assume you would expense 100 units of the Beginning Inventory at $5/unit and only 50 units of Purchases at $7/unit.
Pros of accounting using FIFO
- FIFO follows the natural flow of inventory and, if followed in practice, results in less wastage due to inventory obsolescence
- Accounting for inventory using FIFO paints a more accurate picture of the current value of inventory
- FIFO inventory accounting is transparent, and using it makes it harder to cook accounts. Indeed, FIFO is widely accepted and even mandated for accounting in certain jurisdictions.
Cons
By using lower older costs, the FIFO method projects higher profits, which may not be accurate and may attract higher income tax.
2. LIFO
LIFO (Last In First Out) works on the premise that the newest stock is sold off first. For example, if you made three inventory purchases in a year at $1000, $1500, and $2000, you would first sell assigned COGS at $2000.
As a method of inventory accounting, the International Financial Reporting Standards (IFRS) has prohibited LIFO and is only accepted in the US.
Disposing the last acquired inventory first keeps the COGS high and the profits low. Low profits mean low income tax, which is LIFO’s chief appeal to businesses.
LIFO Pros
- Lower income tax liability – by keeping COGS high and profits low, accounting with LIFO lowers your income tax liability. If inventory prices keep rising, the company can save a lot on taxes
- Current financial position – By expensing the newest inventory first, the company is forced to use the most recent acquisition costs giving a better picture of the company’s revenue against costs
- Better customer experience – if used in practice, the customer often gets the freshest stock, which improves customer satisfaction.
Cons
- Impractical for inventory management – LIFO only makes sense as an accounting method. If you were to use LIFO in disposing of stock, the oldest stock would never get sold, leading to obsolescence and wastage
- Risky during inflation – LIFO is most effective when inventory prices keep rising. However, replacing inventory costs exceeds LIFO value when prices fall during a recession. This undermines the benefit of using LIFO.
- LIFO is banned by the IFRS, meaning that companies that must file their returns elsewhere must also prepare another account using FIFO.
3. Weighted Average Cost
The weighted average cost is a method of costing inventory that assigns an estimated average cost rather than the actual cost to the product.
The average cost is determined by dividing the total cost of goods by the total number of items available for sale.
This formula can be expressed thus
The weighted average cost is ideal for inventory items that are so similar that it is hard to track the individual value of each. For example, average costs are used in the oil industry, where its difficult to differentiate different batches stored in the same barrel.
Pros
- Minimizes the effects of FIFO and LIFO –FIFO and LIFO methods swing to one side on COGSand profit margins, which are flipped when there is a recession and depression. Weighted average costing takes a middle ground which may mitigate the effect of taxes
- Simple and cost-effective to administer – Weighted average costing needs little labor to administer, which saves on time and financial resources
- Transparency and accuracy – average costing is a more transparent way of ascertaining COGSand profit and is harder to manipulate
Cons
- Weighted average costing is ideal only in specific circumstances. You cannot apply it effectively when the inventory items in the batch are not identical.
- If you make large purchases infrequently, weighted average costing may significantly raise or lower your inventory valuation than you would get with FIFO or LIFO.
- Weighted average costing works on the premise that the average lies within a restricted cost fluctuation. If the actual cost goes outside that range, it may cause losses that are hard to recover from.
No one inventory valuation method is universally good or bad. Choose what works for you based on its strengths and weaknesses.
How to Use COGS for Your Business
The concept of COGS has significant ramifications for how you run your business and project its profitability and value to the other stakeholders.
Here are some of the applications of COGS for your business:
- COGS helps you ascertain your company’s gross profit and gross margin. Gross profit is the difference between selling price and COGS. The lower you can keep your COGS, the more profits you have.
By choosing how you evaluate your business’s inventory, you can influence the COGS and the gross profit margins.
- Keeping an eye on Cost of Goods Soldhelps you with pricing your products. A profit is simply a markup on COGS. Therefore properly establishing COGS enables you to set prices that are just right.
- COGS is a critical element in calculating the inventory turnover ratio, which indicates the volume of business the company is doing and is likely to do. Knowing inventory turnover helps with planning.
- COGS can help businesses manage their income tax liability by being able to manipulate their profits. Calculating Cost of Goods Soldusing LIFO results in lower profits which attract lower income tax
- COGS helps establish a business’s size, trade volume, and ability to scale. These metrics are vital to evaluating a company to sell or buy.
Limitations of COGS
Useful as the concept of COGS is, it is not without its limitations that you should watch out for. The limitations of COGS include:
- COGS is simple to manipulate. Changing the order in which you claim to dispose of your assets may push your profits up or down for the same inventory with the same price.
- COGS is rarely static or consistent as it is made up of many components which vary widely per unit for items in the same inventory
- The method of accounting used in valuating inventory has undue influence on COGS, especially across periods, even with no change in sales
- The impact of COGS is easy to underrate as it is not always immediately apparent
Conclusion
COGS has many applications for your business, and a sound understanding empowers you to unlock those applications. Failure to understand the mechanics of COGS may cause financial loss and even have legal and ethical consequences.
For instance, failing to distinguish between direct and indirect costs and including the wrong set in COGS wrongly values your inventory, affecting the applications to which you put COGS.
Use NextSmartShip’s inventory system to keep track of your inventory. The inventory system is designed for e-commerce sellers and integrates with major e-commerce platforms.
NextSmartShip’s inventory system will update you on your orders, stock levels, and movement. The system will also help you with accounting and demand forecasting.
Talk to an expert from NextSmartShip today for advice.
