This comprehensive guide will equip you with a deep understanding of the Cost of Goods Sold (COGS) and its significance for your business. By reading this article, you’ll learn how to calculate COGS, understand the differences between COGS and operating expenses, and explore methods to reduce your COGS, ultimately enhancing your business’s profitability.
Key Takeaways:
- The Cost of Goods Sold (COGS) refers to the direct costs associated with the production of goods sold by a company. Calculating COGS is critical for setting prices, managing business budgets, and determining profitability.
- COGS can be calculated using the formula: Cost of Goods Sold = Beginning Inventory + Purchases During the Period – Ending Inventory. Different inventory cost methods like FIFO and LIFO can be used in the calculation.
- Understanding COGS provides valuable insights into a company’s efficiency and helps in strategic planning. It’s directly linked to a company’s revenues and has a major effect on profit margins.
- COGS and operating expenses differ in that the former pertains to costs directly tied to product manufacturing, while the latter refers to expenses not directly related to the production of goods and services.
- Reducing COGS can significantly increase profitability. Some strategies include leveraging lower-cost raw materials, buying in bulk, negotiating with suppliers, and researching alternative product suppliers.
You need to know the cost of goods sold to calculate your business’s profits. Calculating and defining the cogs is an important factor in setting prices and managing your business budget. So what is the cogs? How do you calculate the cost of goods sold most easily? Why is the cogs a significant element for your business finances? Here is everything you need to know about the COGS and more.
In this guide, we’ll help you understand:
- What Is the COGS?
- What Is the Universal Cost of Goods Sold Formula?
- A Basic Cost of Goods Sold Example
- 6 Main Steps in Calculating Cost of Goods Sold
- What Does the Cost of Goods Sold Tell Your Business?
- Operating Expenses vs. Cost of Goods Sold: What’s the Difference?
- Accounting for Cost of Goods Sold
- How Can I Reduce the Cost of Goods Sold for My Business?
What Is the COGS?
Also known as COGS, cost of sales or finished goods inventory, cogs refers to the cost that comes with goods either manufactured or purchased and then sold. The cost of goods sold is considered a business expense; therefore, it has a major effect on how much profit the company has made. The COGS can find on the business’s income statement, one of the most critical financial reports regarding your company’s accounting operations. You can find the cogs under the categories “income” or “sales,” for which the income statement sets a report annually, quarterly, or monthly. But how to find the cogs at a certain period? Luckily, there is a standardized formula.
What Is the Universal Cost of Goods Sold Formula?
The universal formula on how to calculate the cogs can be defined as follows:
Cost of Goods Sold = Beginning Inventory + Purchases During the Period – Ending Inventory
Another basic version of the cost of goods sold formula can be used as stated in the Balance Sheet:
- Beginning Inventory
- Plus Purchases and Other Costs (at the beginning of the period)
- Minus Ending Inventory
- Equals COGS (at the end of the period)
The COGS formula can also be calculated using two methods: the accounting and inventory cost methods. The accounting method is the method required by the IRS for businesses to account for their inventory. However, this method contains a small exception that involves small businesses. Small businesses with an annual income of $26 million or less can choose not to keep an inventory and not use the accounting method for the past three years. On the other hand, the inventory cost method offers various calculation methods, including FIFO and LIFO, which vary on the type of inventory the business is keeping.
A Basic Cost of Goods Sold Example
Let’s say the company has a $15,000 cost of inventory at the beginning of the year, has purchased $7,000 worth of material and products, and its ending stock has been listed as $8,000. In this case, the cogs can be calculated as follows:
- $15,000 (Cost of Inventory)
- +$7,000 (Cost of Purchases & Other Costs)
- – $8,000 (Ending Inventory)
- = $14,000 (COGS)
6 Main Steps in Calculating COGS
- Determine direct and indirect costs: The cost of goods sold calculation allows you to deduct the cost of products you sell, although you buy and re-sell them or manufacture them yourself. To determine the cost of direct and indirect expenses, you need to list all costs, including material, supplies, labor, and other similar costs.
- Determine facility costs: Facility costs are usually the hardest ones to determine. These usually include costs for buildings, rent or mortgage interest, utilities, and so on. An experienced tax professional can help you calculate your facility costs, considering tax percentages.
- Determine the initial inventory: Merchandise in stock, work in progress, raw materials, supplies, and finished products are all considered a part of the inventory. An important tip while calculating your beginning inventory is to ensure that the beginning inventory this year must be the same as your ending inventory last year.
- Add purchases of inventory items: Keeping track of the cost of each shipment and the total manufacturing cost for each product you add to your inventory is critical in determining this sum. Collecting invoices and any similar paperwork that accounts for purchased products is a good way to keep track of your purchase inventory throughout the year.
- Determine the ending inventory: You can achieve the ending inventory costs by conducting a physical inventory check of your products or simply estimating. Keep in mind that it can also reduce damaged inventory or deadstock from ending inventory costs.
- Calculate your COGS: You now have all the information you need to set your cogs calculator in motion.
What Does the Cost of Goods Sold Tell Your Business?
The cost of goods sold and inventory are two connection-oriented terms that go hand-in-hand when calculating a business’s gross profits. It is why calculating the cogs is an essential factor in determining its profitability. Since the cogs is subtracted from a company’s revenues, it helps measure the efficiency of the company and help come up with new strategies in planning labor, supply, and manufacturing process. The cogs is usually recorded as a business expense on the income statements because it is the cost of doing business. Having an exact estimation of the cogs helps managers, investors, and the finance department to forecast the company’s bottom line.
So what does the cogs tell your business exactly? What happens when the cogs increases? It means that while the business will have less profit for its shareholders, this increase becomes beneficial for income tax purposes. Most companies try to keep their cogs as low as possible to keep their net profits high. Since the COGS is the cost of manufacturing or acquiring the products being sold, the only costs involved in the calculation are the ones that are directly correlated with the production of these products. In other words, COGS includes solely the direct cost of producing goods that customers purchased during a certain period.
Operating Expenses vs. Cost of Goods Sold: What’s the Difference?
A common question asked regarding the cogs is the difference between the cost of goods sold vs. expenses. By now, we know that cost of goods sold is an expense and is listed in the company’s balance sheet. However, there are distinctive dividing lines between the cogs and operating expenses that need to be considered.
Also known as OPEX, operating expenses refer to expenses that are not directly related to the production of goods and services. In contrast, the cogs comes from the sum of costs directly tied to the manufacturing of the products being sold. Rent, utilities, legal costs, and office supplies can be listed under OPEX. In contrast, the cogs includes materials needed to assemble a certain product or the transportation required to bring the products from a vendor to the retailer.
Accounting for Cost of Goods Sold
To make a quick recap, the cost of goods sold equals the sum of the beginning inventory cost and the purchases during the year, minus the cost of ending inventory. Both IFRS and US GAAP allow various policies for the cogs and accounting for your company’s inventory. There are for main calculation methods that can use to determine your inventory cost and cogs. FIFO (First-in-first-out), LIFO (Last-in-first-out), weighted average, and specified identification are the four methods you can choose from to account for your cogs and proceed to the tax process of the operation.
How Can I Reduce the Cost of Goods Sold for My Business?
Direct costs are probably one of the most problematic issues a company will face, regardless of the product it manufactures. Reducing the cogs and keeping them at the minimum throughout the years is a key element in increasing profitability and efficiency. Here are some of the various ways you can choose to balance out your cost of goods sold and achieve an effective cost-benefit analysis.
- Benefit from the lower-cost raw material when possible.
- Purchase in large amounts to receive bulk order discounts.
- Research suppliers that have various alternatives to your products can purchase them at the lowest possible cost.
- Negotiate with your suppliers and vendors for maximum cost-efficiency.
Commonly referred to as the “pulse of the company,” the COGS is a significant metric that every business needs to keep track of and understand thoroughly carefully. The COGS is useful when used appropriately, both for external users, management, and basic inventory management. COGS can help evaluate how well the company is purchasing and selling its stock while benefitting overall profitability.
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FAQs
What is cost of goods sold (COGS)?
Cost of the goods sold (COGS), also known as cost of sales, is the collective expenses and costs related to the production or purchase of the goods and services that end up getting sold. COGS will include: the cost of purchased items, raw materials or parts used to manufacture of goods; direct labor costs; any supplies used in manufacturing and sales; overhead costs; container/packaging costs; storage costs, trade discounts; and more! Expenses that are indirectly related to the production of the goods/services will be excluded from COGS. For example, administrative and general expenses, capital expenditures, sales & marketing expenses, etc. should not be included.
How do you calculate cost of goods sold (COGS)?
Cost of the Goods Sold Formula = (Initial Stock Value + Total Cost of Goods) – Final Stock Value
Should COGS include labor?
Yes, COGS/COS includes direct labor costs, and any direct costs of materials used in producing or manufacturing a company’s products.
Can cost of goods sold be negative?
Ideally, no. Generally, the COGS is expected not to be positive. However, this does not mean that it can “never” be negative. In rare cases, the total of initial stock value and purchases can be lower than the final stock value. If your number of returns exceeds sales for a certain accounting period or there is a correction on the overstated costs from a prior accounting period… it is possible to have a negative COGS.
