Want to look into your business’s profit? If yes, you’d first have to understand how to calculate the cost of goods sold.
Being a business person, you must have come a long way in learning main business pillars like crafting a perfect road map for your business and knowing how to find manufacturers. Still, there’s a lot to learn and build your business strong.
You can better rely on us for that understanding as we are a China sourcing company with over a decade of experience. Hence, we can guide you better on business-related stuff, including COGS.
In this article, we shall explore the cost of goods sold meaning, their importance, and the accounting method to calculate cost of goods sold.
Let’s get started.
What is the Cost of Goods Sold (COGS)?
According to Wikipedia, the COGS is the carrying value of the goods sold during a specific period. Therefore, COGS is also referred to as “cost of sales.”
COGS includes the cost of materials, labor, and other direct costs. However, this amount excludes indirect expenses. Like:
- Salesforce costs
- Distribution costs
In short, the only costs associated with COGS are costs directly related to goods or products sold by a company. These costs also refer to the direct costs incurred by any company while it sells the goods or services. These direct costs are mostly about the production or the purchase of a product. An example of direct costs is direct labor or direct material.
Importance of COGS in Business
The COGS are crucial for businesses. They are an essential metric on the financial statement. The reason? Because they are excluded from a company’s revenue to figure out its gross profit
They are the part of a company’s income statement where the costs are directly related to either the goods or products sold by a company.
The main goal behind finding COGS for a business is to determine the actual cost of merchandise sold in a certain period.
Remember, COGS doesn’t include the cost of goods purchased but not sold or kept in the inventory. I’ve treated CGOS like a GPS system over the years. Helping my team and investors keep on track and monitor the performance of the business.
Accounting Methods for COGS
The value of COGS depends on the inventory costing method adopted by a company. The companies have mainly three types of methods to record the level of inventory sold in a specific period. I’ll show you the difference between each method to help you decide which best suits your business.
1. FIFO (First In, First Out)
2. LIFO (Last In, Last Out)
3. Average Cost Method
4. Special Identification Method （only used for high ticket inventories）
In FIFO, the company sells the goods purchased or manufactured first. As the prices keep going up with the time, the company keeps selling its least expensive product first. Hence, the recorded COGS tend to be lower than those in the LIFO method.
The company’s net income using the FIFO method goes up over time.
The latest goods added to the inventory in LIFO are sold out first. And, in the period of rising prices, the products with a higher price tag are sold first. Resultantly, higher COGS are achieved. However, over time the net income of the companies using LIFO decreases.
Average Cost Method
In the average cost method, the average price of all the stock goods is used to evaluate the value of goods sold. However, the purchase date of the products is not taken into account in this method.
Special Identification Method
In the special identification method, the specific cost of each unit is used to calculate the ending inventory COGS for each period. This method is only used in industries selling unique items—for example, unique jewels, real estate, or cars.
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How to Find the Cost of Goods Sold?
Investors can find the cost of goods sold by adding direct expenses (creating the sold products). They can also list COGS after revenue and before the company’s gross profit on their income statement.
Here are the four steps I personally take to help you calculate the cost of your goods sold.
4 Steps in Calculating the Cost of Goods Sold
If you need to dive a little deeper into the cost of goods sold formula, you need to follow the further steps to calculate COGS.
Typically, accounting and tax experts take care of these calculations with the help of powerful software. However, below we enlist the four steps that many service companies should get the hang of.
Step 1: First off, you should be able to identify the beginning inventory of raw materials. Then, later on, work in the process of the finished goods (based on the previous year’s ending inventory amount).
Step 2: Figure out the overall cost of raw materials purchased. You need to consider a few things at this phase, like freight, trade, and cash discounts.
Step 3: Determine the balance of ending inventory. This balance is found by the company’s inventory-valuation method of choice.
Step 4: Make sure to include every other direct cost of production in inventory valuation.
Cost of Goods Sold Formula
Calculating the cost of your sold goods is not possible without the right formula. So here’s the formula my team and I have used over the years.
Beginning Inventory + Purchases − Ending inventory = Cost of Goods Sold.
Here’s the breakdown of the elements of this COGS formula:
It’s the amount of inventory rolled over (before the accounting period). This previous period can be a month or a quarter.
These are the costs of purchases made during the accounting period.
The amount of ending inventory cost is not sold during the current period. They are usually determined by a physical inventory of products.
Note That: For calculating cost of goods sold, your inventory value and cost accounting must be categorized clearly and consistently.
COGS vs. Operating Expenses
Besides COGS, another term that you often come across as a business owner is operating expenses. However, not every business owner knows the difference between the two.
I’ll help you better understand their key differences. Guiding you through the maze and confusion so you won’t get lost in these two terms again.
Operating expenses – otherwise known as OPEX – are the costs that companies bear during their regular business operation to keep running smoothly.
On the other hand, COGS are entirely the opposite of OPEX. They include general, selling, and other administrative expenses and exclude indirect costs, like, overhead costs.
Check for the expenses of your business. If they don’t belong to the expenses categories of the COGS, they probably are OPEX. To help you understand the operating costs better, here we have stated a few examples:
- Marketing expenses
- Office Supplies
- Salaries/Wages/ Direct Labor Costs (other costs)
Let’s understand the COGS with the help of an example and find the value using the COGS formula. Suppose you are up for calculating COGS for a quarter from January to March. Hence, your recording dates for inventories are:
Beginning inventory: January 1st
Ending inventory: March 31st
For example, if your business has a beginning inventory of $10,000 and your purchase is up to $6,000. And your ending inventory is $3,000. At this point, I’ll show you how to easily find the exact cost of goods using the COGS formula I mentioned earlier.
Beginning Inventory + Purchases − Ending inventory = Cost of Goods Sold
$10,000 + $6,000 – $3,000 = $13,000
So, the COGS for this quarter is $13,000.
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FAQs about Cost of Goods Sold:
Are Salaries Included in COGS?
No, salaries and other fixed costs such as rents, shipping fees, and utilities are not included in the COGS.
What Is Included In the Cost of Goods Sold?
The COGS includes the following things:
• Products purchased for resale
• Raw materials
• Direct cost related to producing or selling the goods
How Does Inventory Affect COGS?
Inventory affects the cost of goods sold adversely. An understated inventory increases the cost of goods sold.
What Are Indirect Costs In COGS?
There are two types of costs involved in COGS: Direct and Indirect Costs. Indirect costs in costs of goods sold are equipment, facilities, warehousing, and labor costs.
It can be challenging to calculate costs of goods sold. However, if you follow the steps you need to calculate the cost of goods sold, you can better look at your business’s profit. Moreover, you can keep a keen eye on achieving sustainable profitability by knowing your COGS.
The cost of goods sold also reveals the actual cost of a company’s products. So, knowing the COGS is crucial to setting product prices and generating profits.
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