Understanding Cost of Goods Sold
Do you regularly add up your cost of goods sold (COGS) but feel somewhat confused or overwhelmed by the required information? You’re not alone. While the concept of COGS seems simple enough, it can be challenging to determine correctly without a lot of research and careful calculation.
Simply put, the COGS is the cost an organisation incurs for goods used in production, including labor and raw materials. It’s vital that you understand your COGS and learn how to differentiate it from other business costs. Not only is it necessary information for your company’s annual tax return, but it will also help you make better decisions about your business.
This article explains how to calculate your COGS with the standard formula and different methods (including FIFO and LIFO), what to include in your COGS, and detail the difference between perpetual and periodic inventory tracking systems. Most importantly for small businesses, we explain the differences between COGS and Operating Costs and COGS and Cost of Revenue.
So, if you’re ready to finally demystify COGS and understand why it is so important to your business, let’s get started.
What is the Cost of Goods Sold (COGS)?
The term “Cost of Goods Sold” (COGS) refers to the costs incurred for a company to sell their goods during a specific period. This includes the costs associated with manufacturing and production, as well as transportation expenses from point A to point B and other supplies, such as packing materials. COGS can also include any discounts on purchase orders or penalties paid when products are returned, among additional fees related to moving inventory where needed most.
Any goods you have in stock and not sold do not go into COGS. They then stay on your balance sheet as an asset.
Most businesses incur two kinds of costs: direct and indirect.
Direct costs
Direct costs are tied to specific products, activities, or services and include labor costs (for labor specifically used to manufacture the products), commissions, and materials costs.
Indirect costs
On the other hand, indirect costs are those that, while necessary to the production, cannot be directly tied to specific production expenses. For example, indirect costs include office rent, cleaning, and utility prices.
Your COGS should only include direct costs. That is, the costs of acquiring or manufacturing the products that you sell in any given period. In addition, COGS figures should only include those directly related to the production or acquisition of the products that a company sells during a period. This includes the cost of materials, labor, and all overhead related to manufacturing.
For example, a shoemaker’s COGS should only include the materials that go into the production of shoes and labor costs to make the shoes. The materials used for shipping and the labor used to sell the shoes should not be included in COGS figures.
How to Calculate Cost of Goods Sold
Calculating your COGS is simple once you know the formula. Start by adding your purchases for the period and to your starting inventory, and then subtract your endpoint inventory for the period. The formula looks like this:
Start Point Inventory + Purchases – End Point Inventory = Cost of Goods Sold
Your start point inventory is the leftover inventory from the previous period, which might be last month, last quarter, or last year. First, you should add any additional inventory that you purchased or produced to this figure. Then, to get your COGS figures, subtract your remaining inventory (the products you did not sell) from your start point inventory.
Here is an example:
Let’s go back to the hypothetical shoemaker. Let’s say your start point inventory was £10000. Since the period has started, you’ve purchased another £2300 in inventory. So, your remaining inventory at the end period is £1450.
Write the formula like this: £10000 + £2300 – £1450 = £10850
With this information to hand, you can start to plan your purchasing patterns for the next period and think about your costs. First, evaluate your product categories and compare them with your sales, working out the profit margins. This way, you can assess which products are making you the most money and which are costing you too much.
Calculating Cost of Goods Sold with Different Methods
While the typical formula detailed above is the most common, companies can use a few other different methods to record inventory levels. These include FIFO (First In, First Out), LIFO (Last In, First Out), the Special Identification Method, and the Average Cost Method. Depending on your business and what you sell, one of these methods might work best for your inventory.
FIFO (First In, First Out)
With a FIFO strategy, you first sell the earliest goods you acquire (by manufacturing or purchasing). After that, prices rise on a slow gradient over time, so the FIFO method helps you sell your least expensive products first.
Compared to using the LIFO method, this translates to a lower COGS and increases your net income over time. This is recommended if you sell very high-value items, where a single item’s cost price can make a big difference to your profit margins.
An example of calculating the cost of goods sold using this method
The ecommerce business Dawn’s Wedding Dresses has 100 dresses in his inventory at the beginning of the month. His supplier charges him £10 per unit.
In the middle of that month, his supplier increases the price to £15 per unit.
During the course of the month, Dawn’s Wedding Dresses orders an extra 200 dresses. Half of which were ordered at £10 per dress and half at £15.
By the end of the month, Dawn’s Wedding Dresses have sold 250 dresses.
Dawn’s Wedding Dresses use the FIFO system, we assume that the stock that was first in (and cost £10) was sold first (therefore first out).
Therefore Dawn’s Wedding Dresses COGS at the end of the month is £2750.
Another way to visualise this would be:
Dawn’s Wedding Dresses sold
The original 100 dresses that they purchased at £10 (£1000)
The 100 dresses they then purchased at £10 (£1000)
50 of the dresses they then purchased at £15 (£750)
Making the total cost of the goods they sold £2700.
· LIFO (Last In, First Out)
With a LIFO strategy, you sell your latest goods first. When prices are rising, you sell your highest-cost goods first, leading to a higher COGS and decreased net income.
An example of cost of goods sold when using the LIFO method
As you may have guessed this is effectively reversing the FIFO method. So now you are assuming you sold goods that came in last, first.
Using the example above, Dawn’s Wedding Dresses Cost of Goods Sold would be £3000.
This is because you would assume they sold:
The 100 dresses they ordered later in the month first purchased at £15 (£1500)
The 100 dresses they ordered earlier in the month purchased at £10 (£1000)
Only 50 of the original dresses they had purchased at £10 (£500)
Making the total cost of goods sold £3000.
Special Identification Method
With the Special Identification Method, you identify the specific costs of each item you hold in your inventory and use this information to come to your ending inventory and COGS for each specific period. Each item is tracked with purchase costs as well as the additional costs it accrues over time (for storage, shipping, and labor, etc.). This enables a highly accurate COGS calculation. This is rarely used by any company due to the large amount of effort required to track this correctly. It is most likely used if you are selling a small number of items that are distinguishable from each other.
Average Cost Method
The average cost method is the most commonly used by ecommerce retailers because it’s the simplest to implement and gives accurate enough results for costs reporting. When you use the Average Cost Method of COGS, you divide your total cost of goods by the number of inventory items you have for sale. By assuming that your costs are weighted equally, you end up with a weighted-average unit cost that you can apply to all units in your inventory.
Example of cost of goods sold when using the average cost method
In this instance, the total inventory purchased by Dawn’s Wedding Dresses costs £3,500. That’s the:
100 dresses they initially had at £10 (£1000)
100 dresses they first purchased at £10 (£1000)
100 dresses they then purchased at £15 (£1500)
To get the average cost of inventory purchase you simply divide the total cost (£3500) by the total inventory count for the quarter (300). Which equals £11.67.
You then multiply that figure by the number of units sold overall (250). Which equals £2916.67, which is your cost of goods sold using the average cost method.
What Can the COGS Tell You About your Business?
Knowing your COGS can help you make smart and informed decisions about the state of your business. To make intelligent decisions for growing your business, you need to understand how your costs affect profitability, so take some time today and calculate your COGS in relation to revenues.
If you’re unhappy with your COGS concerning your revenues, you can start planning and researching new ways to reduce costs. Start by looking for vendors with better prices, a lower-cost warehouse solution, or more affordable shipping options.
Here are three reasons why you need to know your COGS:
Pricing your products
Knowing your cost of goods helps you set your product prices at the right levels, leaving you with your desired profit margin. By staying on top of this information, you can stay on top of your pricing. That means raising and lowering them when necessary.
For example, if your new product costs £32 for materials and labor, you might think you need to sell it at a price higher than £32 to generate a profit. Maybe you put it on sale for £36, anticipating £4 profit for every unit sold. However, if you don’t factor in all of your costs, such as shipping, packaging, and utilities, to create an accurate COGS, you’ll lose money on every unit. So, what you thought of as £4 profit per unit could actually be a deficit of £2.50, landing you in serious financial hot water.
Year-End Taxes
At the end of each tax year, you will need to know your COGS. The IRS allows companies to deduct the COGS for any products they either purchase themselves for reselling or that they manufacture. This is available to both online and offline businesses that list COGS on its income statement.
Setting Your Prices Accurately
If you only estimate your cost of goods, you could inadvertently miscalculate your actual COGS. Using a reliable COGS calculation will ensure you include costs such as utilities and packaging, preventing you from pricing your products too low and losing money.
Planning Future Opportunities
When you keep close track of your COGS, you’re better positioned to identify opportunities for future growth. You can also look for ways to spend less on your materials, suppliers, shipping, and packaging materials.
What Is Included in the Cost of Goods Sold?
Your COGS figures should include the following direct costs:
· Raw materials
· Shipping and handling costs
· Direct labor costs for the employees who create the products
· Finished products purchased from suppliers
· Merchandise
· Supplies and/or ingredients that become a component of the item
· Product containers
· Display units for stores and trade shows
· Purchasing and processing costs
· Repackaging, if necessary COGS does not include indirect costs, including:
· Rent for storage and manufacturing facilities
· Other Storage costs
· Administrative costs
· Overhead costs for your storage or manufacturing premises, including heating, insurance, maintenance, cleaning, and electricity
You might see some conflicting information out there about the indirect costs you can include in your COGS. It is always best to consult your accountant to get an accurate answer for your business.
How is COGS Related to Inventory?
COGS calculations focus on your business’s inventory and its value. If you trade in physical products, your inventory includes the products you sell to customers. Perhaps you purchase your stock from a wholesaler or other supplier or make your products yourself using raw materials. In some cases, you might buy a product from a wholesaler and customise it with raw materials before selling it to the consumer.
All of these items become a part of your inventory, which needs to be counted regularly. Businesses use either perpetual or periodic inventory tracking systems, explained in depth below.
The Difference Between Using Perpetual and Periodic Inventory Tracking Systems
Periodic and Perpetual inventory systems are two different inventory tracking systems. In most cases, the perpetual inventory system is preferred – it’s the one used by most major retailers in the UK and abroad. In most cases, the perpetual inventory method offers many benefits over the periodic system, but there are some instances in which the periodic inventory tracking system might better suit your needs.
The periodic system measures inventory levels and COGS with an occasional physical count. In contrast, the perpetual system continuously keeps track of your inventory, automatically updating the system whenever products are sold, written off for damages, or received from a supplier.
Periodic systems can work well for small businesses with a small amount of inventory. However, if you have a lot of stock, a high sales volume, or many retail locations, you’ll find a perpetual system much more efficient and accurate.
Using the Periodic Inventory System in Practice
If you’re using the periodic inventory system to measure your COGS and inventory levels, you’ll need to conduct physical counts regularly. Most people choose to do this monthly, quarterly, or annually (in rare cases). You’ll record your purchases as they arrive in a purchases account and then update your inventory count on a regular basis.
To calculate your COGS when using a periodic inventory system, use this formula:
Start Point Balance of Inventory + Cost of Purchases – Cost of End Point Inventory = Cost of Goods Sold
Remember – conducting a physical count can be a colossal endeavor, taking a huge amount of labor. It can stretch on for days and can even force you to close retail locations. For example, if you own a grocery store or stationery store, this will involve weighing each tomato and counting every individual pencil! Because it is such a massive undertaking, most businesses only take a physical inventory count once per year, which results in stale data that is hard to use for dynamic business planning.
However, the periodic system might still be your best choice if you sell large-ticket items, such as cars, appliances, or works of art. After all, if you can count your stock with a glance, you don’t need a barcode system or software to do the job for you!
Using the Perpetual Inventory System in Practice
In contrast to the periodic system, the perpetual system is the preferred option for retail businesses and eCommerce warehouses. It uses software that continuously updates inventory balances, giving real-time accuracy when products are received, sold, or written off. However, it does not track theft, so some businesses will also perform “spot check’ inventory counts or year-end counts to track their shrinkage.
Of course, perpetual inventory software has a learning curve, but it will save you a lot of time and energy once you get used to the ins and outs of the system.
If you have a high sales turnover and a large warehouse storing thousands of small items, such as toys, groceries, cosmetics, or tools, you’ll be much better off with a perpetual inventory system. It will help you order more accurately, forecast your future orders, and prevent over or under-ordering.
What’s the Difference Between COGS and Cost of Revenue?
What is the difference between COGS and the cost of revenue? While these two terms may seem similar, they actually have significant differences.
As we’ve detailed above, COGS is the cost of goods you sell. Cost of revenue, on the other hand, includes all expenses that are incurred to provide a service or product, including labour and overhead. COGS does not include any external expenses, such as marketing expenses for selling your products or services. If these items were included in the calculation, then this would give you an erroneous representation of how much it actually costs to manufacture your goods for sale. These costs do not impact what goes into making the products; they are instead related to the sales process.
In short:
· Costs that are directly related to fulfilling orders (i.e., purchasing inventory) will be classified under COGS, while anything else can go under cost of revenue.
· COGS reflects the amount you need to spend to get goods ready for sale.
· The cost of revenue reflects the amount you need to spend to sell your products or services.
What’s the Difference Between COGS and Operating Expenses?
It’s also important to differentiate COGS and operating expenses. COGS, or cost of goods sold, is the total amount of money spent to produce and move a product. Operating expenses are all other costs related to running your business. These expenses include salaries for employees not directly involved in making products or providing services. They also include any marketing campaigns.
Remember, your COGS should not include any of your indirect costs, such as rent for storage and manufacturing facilities, other storage costs, administrative fees, and all overhead costs for your storage or manufacturing premises, including heating, insurance, maintenance, cleaning, and electricity. Instead, these are considered operating expenses, and they are accounted for separately.
Here’s an example to help you understand the difference between COGS and Operating Expenses: If you sell takeaway pints, your cost of goods includes the beer, the takeaway cup, the keg, and the tap. However, it does not include the cost of electricity to run your bar or the labor costs for the employees that pour the beer – those are operating costs.
Is Cost of Goods Sold an Asset?
Your COGS is not an asset, because it is not considered something that your business owns. However, it is also not considered a liability (what you owe). Instead, it is regarded as an expense included in your cost of doing business.
Your business accounting includes five main accounts – assets, liabilities, equity, expenses, and revenue. You (or your accountant) will record your expenses as a debit to your expense account in a journal entry, as well as a credit to your assets or liabilities. If your accountant uses the accrual method for your business, you’ll need to match the cost of goods with the sale of those goods for the expenses to “match.”
Are Salaries Included in COGS?
General and administrative costs are not included in COGS, but certain labor-related expenses might be, as long as they are directly tied to specific sales. For example, suppose a company uses contractors to generate their revenue and pays them commission based on the price charged to customers. In that case, those commissions can typically count as part of COGS. Again, that’s because they’re directly related to generating revenues for the company. If you have any doubt about what you can include in your COGS, speak to an accredited accountant.
Remember – the cost of goods sold is a critical part of any business. This vital data can be used to calculate your gross profit, determine if you need more inventory, and benchmark your profits against competitors in your industry.
Veeqo’s eCommerce inventory management software can help you quickly and accurately calculate your COGS, saving you valuable time and energy.
