Cost of Goods Sold (or COGS) is a key retail accounting number that enables you to determine gross margin or gross profit. By using the COGS calculation, you can measure all the direct costs you incur in the production or sale of your goods during a particular accounting period.
What Is Cost Of Goods Sold? Definition Of COGS
Simply put, Cost Of Goods Sold, or COGS, is the cost you bear for producing or selling products. Bear in mind that COGS, also known as Cost of Sales, includes only the direct costs associated with the production or purchase of the goods you sell and not the indirect costs.
Direct costs include labor cost, freight-in, raw materials, rentals, and overheads related to manufacturing or sale of goods. You cannot include indirect costs such as utility bills for your store, marketing costs, etc. when you calculate COGS.
Direct And Indirect Costs Explained
For example, if you are in the business of manufacturing women’s handbags, your direct costs are all costs in the production of these handbags – labor costs, machinery cost, electricity cost, raw materials cost, and so on.
However, if you are a retailer of women’s handbags, then your cost of business for selling these products such as store rental, labor cost, packaging, commissions paid, etc. are direct expenses for selling your products. Indirect costs you incur such as administrative expenses, interest paid, advertising cost, etc. are not included while calculating COGS as a retailer.
Remember, if you paid sales tax for supplies, then you can include it as a business expense.
Cost Of Goods Sold And Accounting
Cost of goods sold appears in your income statement to reflect the cost of inventory sold for that period of time. By definition, COGS deductions are only applicable to companies that hold inventory. If you run a dropshipping business, cost of goods sold is the purchase price of the product, plus shipping costs. You save on warehousing costs in this case.
Formula To Calculate Cost Of Goods Sold
Here is a simple, straightforward formula you can use:
Cost of goods sold = Beginning Inventory value + Expenses for purchases – Ending Inventory Value
Bear in mind that in this formula, the beginning and ending inventory values are calculated for each product, and for that particular accounting period being considered.
COGS Calculation Example
Let’s go with the above example and assume that you are in the business of retailing women’s handbags. Let us assume you pay $28 per handbag and you sold 20 handbags in a month. You have 30 handbags in stock, valued at $840. You place an order for 10 more handbags during this same one-month period.
In this case, your beginning inventory value is the value of 30 handbags or 30 X 28 = $840
Your expense for purchase is the cost of 10 additional handbags, or 10 X 28 = $280
Your ending inventory value is total inventory (30+10) minus your sold inventory (20)
In this case, that is equal to 20 handbags, and thus the value is 20 X 28 = $560
Cost Of Goods Sold = 840 + 280 – 560 = $560
This is a very simple example, and we explain the nuances of calculating the cost of goods sold further below.
Why is it important to know your COGS?
Since COGS is the cost of conducting business for products sold, you include it as a business expense. COGS indirectly impacts profit. The higher your COGS, the lower your gross profit. By extension, COGS has a direct relationship to the amount of tax you pay as a business owner. As COGS is a business expense, the higher your COGS, the lesser tax you pay after deducting the business expense.
- By calculating COGS, you not only get to know the value of current inventory, but also an idea of operating efficiencies in your business and if you need to regulate inventory build-up.
- You also know what you have as Net Operating Income and get a quick view of profitability. An increase in COGS reduces net profits.
- As a retailer, you must report COGS on in your income statement. It is the cost of doing business that is deducted from sales revenue to determine gross profit.
- As a small business, you will show current inventory as an asset and therefore its value appears on your balance sheet as well.
Accounting methods And Cost Of Goods Sold
COGS calculation is an important criterion to meet under GAAP.
In the handbag example, the unit price of handbags remained constant over time. However in real life, product costs vary with demand, and additional expenses such as storage costs can vary over time as well. In this case, we use inventory valuation methods to decide on COGS for each individual product.
You can value inventory using three methods- First In, First Out (FIFO), Last In, First Out (LIFO) and Weighted Average Cost (WAC). Learn more about these methods and which one to use in this article on Inventory Valuation Methods.
Limitations Of COGS Calculation
COGS gives you greater insight into your inventory cost. But it is one of the metrics that banks, investors, and regulators look closely at. Some companies tend to massage their inventory costs to make their business look healthier than it is. Here are a few loopholes in the usage of COGS to value inventory.
- Inventory is an asset. Companies may exaggerate the value of inventory on hand by including of out-of-date products. This boosts inventory to show a larger value of assets.
- Companies may inflate some overhead costs to minimize taxes.
- Any exaggerated discounts will impact your sales revenue.
- If you miss adhering to GAAP standards to include mark-downs, you will end up with an inflated value of your inventory.
- Inflating purchase returns to suppliers affects COGS and revenue. This, in turn, has an impact on your gross profits.
Your CPA is the best person to advise you on inventory calculation methods. They will also be able to guide you on how best you can adhere to accounting best practices.