“Cost of goods sold” (COGS) refers to the cost of producing the goods sold by a company. Calculating COGS involves knowing the amounts you spend to create your products, which helps in determining whether your business is making a profit. Cost of goods sold is sometimes referred to as “cost of sales.”
Key Points
• Cost of goods sold includes direct expenses like raw materials, labor, and manufacturing overhead.
• Calculating COGS involves comparing the different amounts of inventory stock at the beginning and end of a given reporting period.
• Different inventory costing methods affect COGS figures, including FIFO, LIFO, and weighted average.
• Accurately calculating COGS is crucial for financial reporting and profitability.
• Reducing COGS through greater efficiency or cheaper materials boosts profits.
What Is Cost of Goods Sold (COGS)?
Cost of goods sold comprises the outlay for materials and labor that are directly used to create the product. COGS does not include indirect expenses, such as sales or distribution costs.
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Components of COGS
Understanding the meaning of COGS enables you to manage your business better as you zero in on the relevant cost components. The expenses included in COGS are those directly associated with the production or acquisition of a company’s merchandise.
Some COGS-related expenses are direct raw materials, direct labor costs, manufacturing overhead, and direct costs of production. COGS does not include general and administrative expenses, marketing, utilities, equipment purchases, salaries of management-level employees, insurance premiums, or certain other business liabilities.
Raw Materials
The price of raw materials, such as basic manufacturing supplies or substances, is a major factor in the COGS. The calculation might also include materials for packaging, such as boxes for shipping orders. Businesses that sell goods might have high materials costs, while businesses that sell services would likely spend much less or nothing on materials.
Labor Costs
Cost of goods sold also includes labor costs, including direct labor for creating or assembling products. Administrative costs or salaries of management-level employees are not part of COGS.
Manufacturing Overhead
Another set of costs to add into the COGS is the manufacturing overhead. As with raw materials, the cost of manufacturing overhead (also known as factory overhead) will be higher for companies that fabricate or assemble products than for companies that provide services. Note that, if you’re financing business equipment, expenses related to the loan are not part of COGS.
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How To Calculate COGS
Calculating COGS can be useful as part of a break-even analysis, and you can reassess the figures monthly or quarterly to track the company’s progress. The following formula shows how to calculate the cost of goods sold.
COGS Formula and Example Calculation
The COGS formula is:
Cost of goods sold = (beginning inventory cost + inventory costs) − ending inventory
The components are:
• Beginning inventory: the cost of the goods in the company’s inventory at the beginning of a given time period. This is not the same thing as inventory costs.
• Inventory costs: additional costs incurred in purchasing or creating more inventory during the time period.
• Ending inventory: the cost of the inventory that the company has left at the end of the time period.
There are several ways to determine inventory cost. The inventory cost accounting method that your business chooses will affect its COGS calculation; each business may use a different method. The four common inventory costing methods are weighted average, LIFO, FIFO, and special identification.
• Weighted average: This is one of the simplest methods, where the outlay for the entire period determines the inventory cost. The date that a given unit of inventory was purchased or produced doesn’t matter in the weighted average method.
• LIFO: This acronym stands for last in, first out. In this method, the newest inventory is sold first.
• FIFO: The opposite of LIFO, this stands for first in, first out. In this method, the oldest inventory is sold first.
• Special identification: With this system, each unique unit is tracked and has its own cost. Each unit may be labeled with a serial number.
An example of calculating COGS would be as follows:
• Business XYZ started the month with stock that had a cost of $10,500 (the beginning inventory).
• During the month, the business spent $3,000 for the purchase of materials to make new products (the inventory cost).
• At the end of the month, XYZ had $4,100 worth of goods in stock (ending inventory).
To calculate the cost of goods sold for the month, the formula would be ($10,500 + $3,000) − $4,100 = $9,400.
Why COGS Matters for Your Business
Cost of goods sold is recorded as a business expense on income statements. COGS may be used by investors or managers to estimate a company’s bottom line. A lower COGS means higher net profits (with all other things being equal). Also, the details of your COGS analysis are likely to be relevant to lenders if you apply for a small business loan or business line of credit.
Note that service companies may not have any cost of goods sold at all. Service-only companies don’t have goods to sell. They also do not have inventories. Examples of service-only companies include law offices, real estate appraisers, business consultants, and accounting firms.
Ways To Reduce COGS
Companies can reduce their COGS through purchasing cheaper raw materials or increasing efficiency in the production process to lower costs.
COGS can also be manipulated, either intentionally or mistakenly. Some ways might include overstating discounts, overstating returns to suppliers, overvaluing inventory on hand, allocating to inventory higher manufacturing overhead costs than those incurred, altering the amount of inventory in stock at the end of an accounting period, or failing to write off obsolete inventory. COGS will then be underreported, leading to a falsely high gross profit margin and an inflated net income.
Common COGS Calculation Mistakes
Many people use “cost of sales” and “costs of goods sold” interchangeably. But the calculations aren’t necessarily the same.
• Cost of goods sold involves the direct costs associated with producing goods — or acquiring inventory that has been sold — during a specific time period. Examples include raw materials and pay for factory workers.
• Cost of sales includes the direct costs of goods sold plus any other costs related to generating revenue — generally a wider range of expenses than COGS.
COGS is used for manufacturing and cost of sales is more appropriate for companies that provide services.
A related mistake in calculating COGS is factoring in costs that should not be included. Some examples: general and administrative expenses, marketing, utilities, equipment purchases, rent or mortgage payments, salaries of management-level employees, or insurance premiums. An accountant will help you categorize your expenses in order to get the most accurate data.
The Takeaway
Cost of goods sold represents the sum of a business’s direct costs for producing the merchandise it sells. The monthly or quarterly calculation includes any direct costs that a company incurs for manufacturing, purchasing, or selling products. It’s worth tracking this information, as lowering COGS can boost net profits.
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FAQ
What is included in the cost of goods sold?
Costs of goods sold includes the direct outlays of a business for expenses closely associated with the production of the goods it sells. COGS includes things like direct labor, direct materials, direct costs of production, and manufacturing overhead.
How does COGS impact business profitability?
COGS affects a company’s profits as COGS is subtracted from revenue to show gross profit. If COGS increases, the business will have less profit. As a result, businesses try to keep their COGS low.
Is COGS the same as expenses?
COGS includes the costs and expenses that are directly related to the production of goods. However, COGS does not include all expenses. Indirect expenses, such as sales force costs, are not included in COGS.
Can service-based businesses calculate COGS?
Service-based businesses usually cannot calculate COGS. Companies that offer only services don’t have goods to sell, and they don’t have inventories. Examples of service-only companies include law offices, real estate appraisers, business consultants, and accounting firms. Instead of COGS, these businesses can calculate “cost of sales.”
How do I reduce my cost of goods sold?
Companies can reduce their COGS through cheaper raw materials or more efficient production.
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