The Hustler's Digest StaffDo you know your business’s cost of goods sold? Read this article to have an in-depth understanding of how to find the cost of goods sold.
As an entrepreneur, you have tons of responsibilities; finding out your business’s cost of goods sold is one of them. You do not have to master accounting to run your business; however, it is imperative to learn the basic principles of accounting. Learning the basics will provide you with clarity on your company’s financial statements.
You must grasp one fundamental concept in accounting: the cost of goods sold (COGS or CGS). Correctly calculating the cost of goods sold helps you price accurately and deduct your business expenses appropriately for tax purposes.
Monitoring COGS can help you identify if you are overspending on material inputs or suppliers and need to make adjustments to ensure profit. Cost of goods sold is the cost of a product that unrolls to the accounts of a distributor, manufacturer, or retailer. Calculating the cost of goods sold (COGS) for products a company manufactures or sells may have complications, depending on the number of products and the complexity of the manufacturing process.
Understanding COGS and managing its components can impact a business’s profitability either positively or negatively. Learn how to understand these costs better, why they are essential, and how to find them for your business.
What is COGS?
Cost of goods sold or COGS refers to the costs incurred upon the company’s account to make products. Depending on the type of business, the cost of goods sold can be much easier or more difficult to calculate. A retailer, for example, has a pretty clear understanding of what goods and inventory are needed in the calculation. A different industry with more manufacturing requirements may require a more complicated calculation.
Cost of goods sold includes the two main costs, i.e., direct labor and material costs. The cost of goods sold only consists of the expenses that go into the production of each product or service you sell (e.g., wood, screws, paint, labor, etc.). Calculating the cost of goods sold does not include the cost of products or services that you create but do not sell.
What is included in the cost of goods sold?
There are numerous items that make up costs of goods sold including:
- Cost of items intended for resale
- Cost of raw materials
- Cost of parts used to make a product
- Direct labor costs
- Supplies used in either making or selling the product
- Overhead costs, like utilities for the manufacturing site
- Shipping or freight in costs
- Indirect costs, like distribution or sales force costs
- Container costs
- Trade or cash discounts
Why is COGS important?
The COGS provides meaningful insight into your business’s profits over a certain period. In addition to that, it also describes the overall financial health of your business. It is of great importance in the eyes of accountants, entrepreneurs, or finance experts because of the severity of the information it extracts. Let’s walk you through why COGS is necessary for a better financial position.
Pricing
Pricing your products and services is one of the most significant responsibilities of a business owner. If you price your products too high, you may see a decrease in interest and sales. Whereas, if you price your products too low, you will not yield enough profit. This matter leads to the query: How do you know if you are charging enough to cover your costs?
Knowing your COGS can help. If you know your COGS, you can set prices that leave you with a healthy profit margin. Thus, you can determine when prices on a particular product need to increase.
Determines profitability
The cost of goods sold helps determine your gross profits and net profits. Once you have CGOS, you can subtract it from sales to yield gross profit. You can then add operative expenses, taxes, and other expenses as part of an income statement. Knowing your business’s profits can help you:
- Make financial decisions
- Seek financing (e.g., business loan)
- Determine if you need to make adjustments
Helps to separate direct vs. indirect costs
Some expenses occur each month regardless of whether your company earns a dollar or not. These are your indirect costs. When you separate your COGS, it gets easy to figure out the total indirect costs. It is imperative to have a handle on these expenses. Knowing what you could be on the hook to pay every month will remind you of your break-even point.
Help you see how efficiently you manage your production
Over time, do you see your COGS increase and decrease in line with how much you sell? That will give you an indication of whether costs related to what you sell are increasing, decreasing, or remaining the same. If your costs are growing and your sales are not growing, that might be something you want to investigate to find out the causes.
Cost of goods sold for services
Businesses use numerous metrics to understand their financial position and stability. Many companies calculate the cost of goods sold to help establish baseline expenses and costs. While often associated with products, the cost of goods sold is also a helpful calculation for businesses in the service industry.
Cost of goods sold, or COGS, is a metric used primarily by product-based companies and industries that determines how much your company spends on product-related expenses. COGS do not include any overhead or fixed costs your company incurs whether or not you sell any products. COGS can also apply to those companies that provide services rather than products.
In accounting, the terms ‘goods’ and ‘services’ have a meaningful place as it helps create a difference while applying accounting standards. Since there are usually no “goods sold” in a service-based company, many organizations refer to this metric as revenue or sales cost. This figure depicts the expenses your business incurs in the process of providing a service to your customers. Service-based COGS does not include any overhead or fixed expenses like traditional COGS.
There is a primary difference between COGS and COGS for services, which is critical to understand.
Physical products
Companies that sell a physical item use COGS to itemize the materials used to produce and manufacture their product. Service-based businesses might include raw materials used in the service they provide, but the expenses these companies have in their COGS for services calculation are often not materials-based.
Related expenses
A company’s associated costs from their sales often differ substantially between a product and service. For example, many service-based companies must include direct labor expenses separate from other salaries and wages as a part of COGS. In contrast, product-based companies may not need to make that distinction.
Clarity
Businesses that sell physical products use the term COGS almost exclusively. Companies that offer services consider COGS for services expenses as a cost of revenue or cost of sales on their income statement and tax documents for clarity and transparency.
How to calculate the cost of goods sold from an income statement?
An income statement is a financial statement in which a company reports its income and expenses. If income exceeds expenses during the reporting period, there is a net profit or vice-versa. Generally, you report the cost of goods sold under expenses as the costs directly related to either the product or goods sold by a company or the costs of acquiring inventory to sell to consumers.
If the cost of goods sold exceeds the revenue generated by the company during the reporting period, the revenue did not generate a profit. Keep in mind that any loss due to one business activity may be offset by another income-generating activity and still result in a net profit for the company. Although you report the cost of goods sold on the income statement, you prepare the COGS statement beforehand. Moreover, if you have sales and Gross profit on your income statement and no CGOS, you can find COGS by subtracting sales from Gross Profit.
Cost of goods sold calculator
With the advancements in software technology, there are numerous accounting activities that you can perform online with no or fewer human errors. There are plenty of online calculators to help you find each accounting cost, including the cost of goods sold. You can find several reliable online calculators, which will help you find the cost of goods sold for your company with the minimum required effort.
Following are a few of the best online cost of goods sold calculators that you can use to your benefit:
- WpCalc: Its finance calculator helps you find an accurate cost of goods sold for your company. You need to provide the required data such as beginning inventory, ending inventory, and purchases to determine the CGOS.
- com: It is another calculator that facilitates online calculation for financial costs, including the cost of goods sold. Amateurs, who are not accounting experts, can seek assistance from here.
- Deputy: This site provides a downloadable calculator that you can install on your device and find the cost of goods sold anytime.
Online calculators are of enormous help; however, you still have to grasp a few basic concepts such as valuing your inventory, beginning inventory, purchases, ending inventory, and a few other costs. Let’s walk you through these concepts to facilitate you in this regard.
How to value your inventory?
As an entrepreneur, you need to decide how to value your inventory. You can choose to value your inventory at cost, lower cost, or another way. If you use the cash accounting method for your business, you must value your inventory at cost. You must check with your accountant, bookkeeper, or anyone else who prepares your taxes if the ways you work out costs, quantities, or valuations of your products have changed.
If there have been changes, you must incorporate these modifications when reporting your tax. You should seek advice from a financial professional about the best valuation method to use.
What is your beginning inventory?
Your beginning inventory is the entire cost of every product in your inventory at the start of the year. This figure should match the inventory at the end of last year. Where there are discrepancies between your beginning and ending inventory of the previous year, you will need to explain tax purposes.
Cost of purchases
You need to find out the total amount of every product you bought throughout the year in inventory that you need to sell. You can not add products at this cost for your personal use. If your company is the manufacturer, you need to incorporate the total cost of every raw material and item you bought throughout the year.
Cost of labor
Your labor cost consists of your company’s cost for the employees who work specifically to make your goods and products from raw materials and parts. Cost for finance, sales, marketing, administrators, etc., is excluded from this cost of labor calculation.
Cost of materials & supplies
These costs must be specifically associated with making your goods or products. What are your other costs? Your additional costs include overhead expenses for rent and utilities for the premises where you make or assemble the goods or products. It also provides freight on materials, supplies, and shipping container costs.
What is your ending inventory?
You will find your ending inventory by working out the total value of every item in your inventory at the end of the year.
Cost of goods sold example
Running a business involves several hidden costs. These costs can be equipment and maintenance upgrades, employee turnover, credit card fees, interest on loans, permits and licenses, and more. Understanding these costs is key to ensuring that your business is flourishing and meeting its financial goals. Costs of goods sold help understand the incurred costs, profitability, and pricing strategy.
We will present you with a few examples of the cost of goods sold for your understanding.
Example 1:
Consider a basic example of Company ABC manufacturing a packet of pens. The direct cost
of manufacturing is $1.00 / packet. Below are statistics
Opening Inventory as of 01/01/2021: 3500 packets
Closing Inventory as of 12/31/2021: 500 packets
Costs incurred during the year are as under:
Purchase cost: $100,000
Discounts received: $5,000
Freight In: $25,000
Solution:
Cost of opening Inventory: 3500 packets x $1.00 = $3500.00
Cost of closing inventory: 500 packets x $1.00 = $500.00
Hence, the calculation of Cost of Goods Sold is
COGS = $3,500 + $100,000 – $5,000 + $25,000 – $500
COGS = $123,000
Example 2:
Let’s say you want to know your cost of goods sold for the quarter. You record beginning inventory on January 1 and ending inventory on March 31 (end of Quarter 1). Your business has a beginning inventory of $15,000. Your purchases total up to $7,000 for the quarter, whereas your ending inventory is $4,000. Find your total COGS for the quarter using the cost of goods sold calculation.
Solution:
COGS = Beginning Inventory + Purchases During the Period – Ending Inventory
COGS = $15,000 + $7,000 – $4,000
Your cost of goods sold for the quarter is $18,000.
Cost of goods sold formula manufacturing
Efficiency is the lifeblood of any manufacturing company. If the processes and procedures work smoothly and efficiently, the company achieves higher profits. However, profits may suffer if the methods and techniques do not work as anticipated. Acquiring the cost of goods sold comprises a detailed calculation. Let’s present you with a formula that you can use for your benefit:
Beginning Inventory of Finished Goods
Add: Cost of Goods Manufactured
Equals: Finished Goods Available for Sale
Subtract: Ending Inventory of Finished Goods
Equals: Cost of Goods Sold
How is the cost of goods sold affected by inventory costing methods?
Each inventory valuation method has a different effect on your cost of goods sold (COGS) and ending inventory value. Some ways produce a high COGS, thus lower gross profit in the income statement and a lower ending inventory value. However, some methods yield lower COGS, higher gross profit, and a higher ending inventory value. Hence, it is arguable that businesses pick an inventory costing method that best suits their gross profit outcome and thus taxable income.
On the other hand, applying a flawed cost-flow assumption to your inventory means that the COGS and revenue do not match correctly, which may result in misinformed business decisions. Finally, if you deal in physical goods, inventory is easily the most significant current asset on the balance sheet.
Popular inventory valuation methods
By far, the most popular inventory valuation methods are First-In-First-Out, Last-In-First-Out, and Weighted Average Cost. The generally accepted accounting principles (GAAP) in the States allow all three to be used. However, the International Financial Reporting Standards (IFRS) do not permit LIFO to be used for reasons we shall see later. Nonetheless, each method produces a different outcome because they make various assumptions about the flow of costs.
1. First in, first out (FIFO)
FIFO says that you will sell the oldest goods in your inventory first. So, assuming that prices rise over time, the ending inventory is valued higher at recent costs. The COGS is lower because it bases on cheaper, earlier costs. This produces more gross profit and a higher taxable income. FIFO is popular and widely accepted because it follows common sense in running a business: you want to sell your oldest inventory first. Also, you report recent costs in the ending inventory on the balance sheet.
2. Last in, first out (LIFO)
LIFO assumes the opposite: that you will sell your newest goods first. When prices rise, the ending inventory is valued lower at older costs, COGS is higher, and thus gross profit and taxable income are relatively lower. The accounting experts commonly use LIFO in the United States; however, it is not permissible in other countries because it has the effect of depressing gross profits and taxable income.
3. Weighted average cost
Weighted Average Cost or Average Cost assumes that you sell your goods all simultaneously. As a layperson, you must be wondering, how? Commodities such as oil are physically indistinguishable and easily substituted. Crude oil bought earlier is not all that different from oil bought today. Relevant personnel simply pour into holding tanks and mix up. Thus, you can price these commodities using the average cost of all goods in the inventory.
Drawbacks of cost of goods sold
COGS calculation has so many moving parts, one can be easily prone to errors and subject to manipulation. An incorrect COGS calculation can obscure the true results of a business’ operations. It can also result in misrepresentation of net income and tax liability. At the very least, this can lead to wasted time and lost opportunities. At worst, there can be ethical and legal implications. Following are the few common drawbacks that you can easily encounter in your company’s books:
- Allocation of costs to inventory higher than those incurred
- Overstating discounts
- Overstating returns to suppliers
- Altering the amount of inventory in stock at the end of an accounting period
- Overvaluing inventory at hand
- Failing to write off obsolete inventory
Conclusion
Every entrepreneur must be familiar with the concept of the cost of goods sold. You may not be an accounting expert, however, to understand where your business is moving, you must know how to find cost of goods sold. The cost of goods sold helps to reach gross profit and net profit if done right. The amount of cost of goods sold includes the cost of any materials used in the production of the goods and also includes the direct labor costs. You can manually find out the cost of goods sold, however, there are numerous online COGS calculators available to use.
