What Is Cost of Goods Sold (COGS) & How to Calculate It
Monitoring your Cost Of Goods Sold or COGS can help improve your profitability. It’s also a tax-deductible expense for manufacturers, retailers, and wholesalers. This post tells you about COGS and provides an example that explains how it’s calculated.
Small businesses can improve their profitability by keeping a close watch on their cost of goods sold. These are the direct expenses related to the products that a company sells to its customers.
Every manufacturing company calculates its cost of goods sold, as do retailers, wholesalers, and distributors. But a service company may not have any cost of goods sold.
The cost of goods sold is also referred to as COGS or cost of sales. A firm’s gross profit is the sum left over after deducting COGS from its sales revenue.
The cost of goods sold calculation is important as COGS is a deductible expense for computing a company’s income tax liability.
In this post, we’ll explain the term “Cost of Goods Sold” and tell you the types of expenses you need to consider when calculating this figure. Additionally, we’ll provide an example to show you how your accountant or bookkeeper does the COGS calculation.
Understanding the cost of goods sold formula
The cost of goods sold is one of the income statement basics you need to know. It’s an expense that appears in your income statement and includes direct material, direct labor, and several other costs.
This is how it’s calculated:
Cost of goods sold = (Beginning inventory + Cost of goods) - Ending inventory
Here is a brief explanation of each of the components of the COGS formula:
Cost of goods sold: An expense in your company’s income statement. It pertains to a specific accounting period, like a year or a quarter. Lowering the cost of goods sold will enable you to increase your company’s gross profit.
Beginning inventory: The cost of inventory at the beginning of the year. It’s the same as the figure for the inventory at the end of last year.
Cost of goods: The purchases you made during the year. It includes the cost of the products you bought for resale as well as the raw material cost you incurred. Typically, the cost of goods also includes:
- The cost of freight for the goods and raw materials you bought.
- Storage costs.
- Direct labor costs.
- Overhead costs incurred in your factory.
Ending inventory: The value of your inventory at the end of the year. It will be the beginning inventory for next year.
When your CPA or accountant calculates the beginning and ending inventory, there are three inventory costing methods that can be used. You need to choose one and use it consistently. The three methods are LIFO, FIFO, and average cost.
LIFO: LIFO or Last In, First Out, is an inventory valuation method that assumes the most recently produced goods are sold first.
FIFO: First In, First Out, works the opposite way. The goods produced or purchased first are sold first.
Average cost: As the name implies, an average cost is assigned to each item in inventory. So, the date of acquisition or production is not important. Instead, the average cost is calculated by dividing the cost of goods by the number of items.
Let’s understand how the cost of goods sold is calculated with an example.
Cost of Goods Sold - An Example
Acme Distributors is in the business of selling office furniture. At the beginning of 2020, the company had an inventory valued at $50,000. In 2020, it bought goods for $300,000 and spent an additional $50,000 on factory costs, freight, and storage. At the end of the year, its inventory is valued at $60,000.
Here’s the same information in tabular form:
Acme Distributors
|
|
Amount |
|
Inventory on January 1, 2020 |
$50,000 |
|
Purchases in 2020 (includes $50,000 for factory costs, freight, and storage) |
$350,000 |
|
Inventory on December 31, 2020 |
$60,000 |
To calculate the cost of goods sold, we’ll plug these numbers into the Cost of Goods Sold formula.
Cost of goods sold = (Beginning inventory + Cost of goods) - Ending inventory
Cost of goods sold = ($50,000 + $350,000) - $60,000
Cost of goods sold = $340,000
Some factors to consider when calculating the cost of goods sold:
As you can see, the COGS calculation involves three variables: beginning inventory, purchases during the period, and ending inventory.
When you are computing the figure for “purchases during the period,” it’s essential to know which costs need to be included. Any expense directly connected with producing goods that will subsequently be sold should be considered.
So, labor costs incurred in the factory for producing goods for sale would increase the cost of goods sold. These are also referred to as “direct labor costs”. However, salaries paid to managerial staff will be excluded. Additionally, expenses on sales and marketing should not be taken into consideration when calculating COGS.
The other two variables in the cost of goods sold formula are beginning inventory and ending inventory.
Conclusion
When you’re calculating COGS, it’s essential to know both these values. However, for certain categories of goods, it isn’t practical to keep track of each unit of inventory. So, your accountant may not be in a position to ascertain which units were sold in the year. Companies adopt an inventory valuation method such as First In, First Out, or Last In, First Out to overcome this problem. It’s crucial to continue using the same method every year. If you don’t, it could affect the accuracy of your gross profit figure.
