Cost of Goods Sold (COGS): Meaning and Formula

The cost of goods sold (COGS) plays a crucial role, whether your business sells products or services.

By understanding what it means and how it affects your company's overall profitability and financial health, you'll be able to track spending better to increase profits and maximize efficiency.

This article details the definition of this concept and shares its formula. It also gives you a lot of tips and information necessary for the long-term success of your venture!

What Is "Cost Of Goods Sold"?

COGS (cost of goods sold) is an accounting term that refers to the direct costs associated with producing and selling a product or service. This can include materials, labor, and overhead expenses. To determine its gross profit, a company subtracts COGS from its revenue.

#DidYouKnow Many industries use "cost of sales," "cost of revenue," and "COGS" interchangeably. 

What Is COGS Used For?

It helps businesses get a detailed picture of their stock or inventory investment throughout the production cycle. Accurately tracking your COGS allows you to make:

• smart pricing and production decisions
• informed business decisions about expenses, profits, yields, and growth potential

Your COGS also affects your taxes as it counts towards a deduction. For businesses with no inventory (service-based companies such as law firms or business consultants), there is no COGS. These businesses calculate something slightly different, known as the "cost of services."

#DidYouKnow Calculating inventory costs is vital to know how much money you have tied up in unsold stock and what the expected return on that investment is.

Types of Cost Of Goods Sold

• Variable COGS. These vary directly with the level of production or sales, such as raw materials, direct labor, and direct overhead expenses.
• Fixed COGS. These are costs that do not vary with the level of production or sales, such as rent, utilities, and insurance.
• Semi-variable COGS. A combination of variable and fixed costs. An example would be machinery maintenance costs because they may not change with the production level but can vary depending on the usage.

What Does The COGS Include?

Generally, the COGS includes the following:

• Raw materials
• Direct labor
• Direct overhead
• Freight in
• Manufacturing supplies
• Factory overhead
• Inventory shrinkage
• Subcontracted work

What The COGS Doesn't Include

• Selling, general and administrative expenses (SG&A), such as salaries, rent, and utilities
• Marketing and advertising expenses
• Research and development expenses
• Depreciation and amortization
• Interest expenses
• Income taxes
• Extraordinary items (e.g., losses from natural disasters)
• Non-operating income (e.g., interest income from investments)
• Non-recurring items (e.g., one-time gains or losses)

How To Calculate The Cost Of Goods Sold

COGS Formula

COGS = Beginning inventory + Purchases - Ending inventory

• Beginning inventory is the value of the raw materials, work-in-progress, and finished goods that a company has at the beginning of a period.
• Purchases refer to all inventory purchases between the beginning and ending inventory.
• Ending inventory is the value of the raw materials, work-in-progress, and finished goods that a company has at the end of a period.

#CaminoTip  Many businesses depend on software programs for beginning and ending inventory amounts. It's a good idea to set aside some time and tabulate product counts manually to verify totals.

Step-By-Step Instructions

Determine Your Parameters

Decide for what period you'll calculate the cost of sales. You should typically do this every fiscal year or quarter. That said, different time parameters may apply depending on the business. Each business must also decide which accounting and inventory methods are most appropriate and how frequently they should calculate the COGS.

Determine The Beginning Inventory

Your starting point should be the value of all inventory in stock at the beginning of the period. To get this number, you'll need to account for

• Raw materials (wood, fabric, metal, and anything else used in production)
• Work-in-progress goods (anything that your business is currently manufacturing)
• Finished goods (everything ready for sale)
• Resale goods

Add The Cost Of Purchases Or Manufacturing Costs

This includes:

• raw materials
• labor
• overhead costs incurred in manufacturing or purchasing the goods

Manufacturing costs may include:

• Labor (wages or salaries of employees involved in the production process)
• Production supplies (supplies necessary for the production process, such as packaging materials, tools, and lubricants)

Purchase costs may include the following:

• Cost of goods purchased (the raw cost of goods purchased during the period)
• Freight and shipping costs (transportation and shipping expenses associated with bringing the goods to the point of sale)
• Import and export duties
• Insurance (the cost of any insurance required to protect the goods during transportation or storage)

Add Any Additional Costs Of Getting The Goods Ready For Sale

Round up and account for any additional presale costs integral to getting the goods to the point of sale. Freight is a typical example of an additional cost not included in other categories.

Subtract The Ending Inventory

Now it's time to apply your numbers to the COGS equation: COGS = Beginning inventory + Purchases - Ending inventory. The result of this calculation is the COGS for the period.

#DidYouKnow You may then subtract the COGS value from the revenue generated by the sales of the goods to determine the gross margin.

Example

Here is an example of how to calculate the COGS for a business that manufactures and sells widgets:

• Starting Inventory: The business has 1,000 widgets at the beginning of the month, costing $5,000.
• Purchases: During the month, the business buys an additional 2,000 widgets at $10,000.
• Ending Inventory: At the end of the month, 1,500 widgets remain in inventory.
• Final calculation

To calculate the COGS for the month: COGS = (Starting Inventory + Purchases) - Ending Inventory COGS = ($5,000 + $10,000) - $7,500 COGS = $7,500 So the business's COGS for the month was $7,500. Depending on your business, you may need to dress it up to include expenses such as:

• shipping
• taxes
• any additional costs you incur to create and sell your product

How To Reduce The COGS

Here are some basic examples of cutting COGS down, but remember that only some strategies will work for some companies.

• Negotiate with suppliers for lower prices on raw materials and components.
• Streamline production processes to increase efficiency and reduce waste.
• Outsource non-core activities to lower-cost providers.
• Implement just-in-time inventory management to reduce carrying costs.
• Use technology, automation, and data analysis to improve operational efficiency and reduce costs.
• Make use of economies of scale by increasing production volume.
• Take advantage of government incentives and tax breaks.
• Review and eliminate underperforming products or product lines.
• Utilize a cost-benefit analysis to determine which expenses you can cut without impacting the overall quality of your products.
• Continuously monitor and review your expenses, and look for ways to reduce costs on an ongoing basis.

More ways to reduce manufacturing costs

Accounting And COGS

There are different accounting methods. Which one you choose will vary by industry.

LIFO

LIFO (Last-In, First-Out) is a method of accounting for inventory that assumes that the last items added to a company's stock are the first ones sold. These businesses often use LIFO because it better reflects their current cost of goods sold and gives a more accurate picture of their financial performance. Companies in the retail and wholesale industries that deal with perishable goods or goods with a short shelf life (such as food, electronics, and fashion) commonly use the LIFO accounting method.

FIFO

FIFO (First-In, First-Out) is a method of accounting for inventory that assumes that the company sold the first items added to the inventory. FIFO better reflects the physical flow of goods and gives a more accurate picture of inventory turnover for these businesses. For example, companies in the manufacturing industry that produce goods with a long shelf life commonly use the FIFO accounting method because they have a relatively stable cost of their inventory items.

Additional Methods

Examples of other methods include:

• Average Cost. Suitable for businesses that incur occasional extreme costs that may otherwise throw off the COGS average.
• Special Identification. Suitable for companies that deal in unique items like real estate or cars.

How Does the Cost of Sales Affect the Price of Sales?

If you don't have a handle on your cost of sales, it's nearly impossible to price your products to make a profit. Likewise, pricing items too high causes demand to suffer, and sales may plummet.

Once you keep on top of the cost of sales, it's easier to determine to price.

For example, if it costs $30 to produce a product, a business owner may set pricing at $45 to $60 to recognize a profit. If they don't know the exact costs to produce a profit, they're merely guessing at pricing. The same business owner who prices an item for $45 and it costs $50 to produce quickly loses money, considering that fixed and variable costs remain constant. Once you cover all your direct and indirect costs, you can be more competitive with pricing. Even so, history proves that customers will only pay so much, and pricing has to keep pace with what's trending in the market.

Cost Of Goods Sold Best Practices

Your final numbers are only as accurate as your processes and systems. If miscalculated, the COGS can lead to inaccurate financial statements, resulting in overstating profits and expenses. This can create problems with your taxes and cause you to make poor business decisions, such as:

• Setting prices too low
• Setting prices too high
• Not investing enough in the proper inventory

And these mistakes can cost you a lot in the long run. By following these best practices, you can help ensure that your COGS calculation is accurate, consistent, and reliable. The calculation will provide valuable insights into your business's financial performance and help you make more informed decisions.

Keep Accurate Records

Make sure to track all costs associated with producing and selling your products or services. This should include materials, labor, and overhead expenses. Companies with scattershot records will need extra time to calculate their COGS or, at worst, will come up with inaccurate results.

Use Consistent Methods

Choose a method for calculating COGS that is appropriate for your business and use it consistently. This will typically be First-In, First-Out (FIFO), or Last-In, First-Out (LIFO), although you may choose another method so long as it is suitable for your business.

Regularly Review And Update Inventory

This helps you ensure you get all the information when calculating your COGS. Accurate records of your beginning and ending inventory are vital to getting the correct numbers.

Reconcile COGS With Financial Statements

Ensure that you reconcile the COGS with other financial statements, such as the income and balance sheets. This is your way of double-checking that the numbers match and that your accounting is accurate.

Review And Adjust Regularly

Review and adapt your COGS calculation regularly. You may need to do this annually or quarterly, so you don't fall behind.

Tips to Increase Sales and Profits

Here are a few more helpful tips that will help your business grow:

Listen To Your Customers

Both positive and negative feedback is essential to help keep you on a steady course. Your customers want to know that the person in charge is available to resolve issues, listen to recommendations, or respond to glowing reviews about your business.

Implement Lost Leader Pricing

To create a buzz about your quality products, you can attract customers by lowering pricing on one or more select items. No, this isn't a bait-and-switch tactic where you substitute an inferior product instead of a superior one. You know, going in that you may lose money, but there's also the possibility that customers will buy additional products.

Spend Time Choosing The Right Sales Team

Finding the right people to sell your products can mean the difference between mediocre and a substantial increase in sales. In most situations, it's not necessary to spend more money on additional employees but to provide training and incentives for your existing sales staff. A more diverse team also increases your chance of reaching all types of people.

Offer Discounts Strategically

If you offer seasonal discounts for a limited time, customers may look closely at your other products. Without going overboard, you can build discounts into your marketing plan throughout the year because customers love deals no matter when they're offered!

Market Your Products Differently

If sales seem to have stagnated, reach out to your existing customers and, in the process, find new ones. Nearly everyone these days has a social media account. You can use these and other tactics to reach people.

Get A Loan

Getting more capital to purchase goods or to implement any of the previous tips can help your business thrive. For example, if you reduce your cost of goods sold by investing in new machinery, you'll gain a long-term edge over the competition. If you need a financial push in the form of a loan, we're here to help. At Camino Financial, we help all business owners looking for a financial partner. Get a quote today and start growing your business. Apply For A Business Loan!