Table of Contents
Does your business sell products? If yes, then you must know everything you can about the Cost of Goods Sold or simply COGS.
But don’t fret if you know nothing about it yet.
In this article, we’ll walk you through what COGS is, why it is important for a business, what to include in the Cost of Goods Sold, its formula, and much more. Let’s begin!
» What is the Cost of Goods Sold?
In simple terms, the cost of goods sold (COGS) is nothing but the direct costs your company incurs for producing the products you sell. These costs include all the direct expenses, such as labor and raw material costs, done towards creating the goods. Meanwhile, all the indirect expenses, for instance, product sales, marketing, and distribution costs, do not fall under COGS.
Also known as the cost of sales, COGS is a crucial sales and business metric. It helps you ascertain the value of your sold inventory in a stipulated time period. With this number, it becomes possible for you to compare your sales number and check the level of progress you’ve made over time.
» Why Should You Care about the Cost of Goods Sold (COGS)?
The cost of goods sold will be deducted from your business revenues to arrive at an accurate gross profit number. COGS, thus, makes for a vital financial statement metric. Moreover, the cost of goods sold on the income statement will be marked as a business expense. That’s because COGS inherently is your cost of doing business.
Keeping that in mind, the higher your COGS, the lower would be your net profits. And the lower your cost of goods sold, the higher would be your net income.
With a clear COGS figure, it becomes possible for companies to attract the right investors, analysts, and managers. On the other hand, analysts, shareholders, and investors can precisely understand the financial standing of a business through COGS. Analyzing and forecasting the bottom line of a company also becomes simpler.
» Things You Can Include in the Cost of Goods Sold
The cost of goods sold is the expenditure you make as a company for manufacturing or acquiring finished goods or products up for sale within a particular period. Thus, the costs that would be included here must be the direct expenses you make for the product production. For example, labor costs, raw material expenses, and manufacturing expenses.
To make things simpler, let’s take a look at what you can include in COGS as a retailer and manufacturer.
› Cost of Goods Sold Formula for Retailers
For people into a retail business, COGS is comparatively easier. It includes expenses directly related to your inventory. Here is a brief list of what would go in your COGS:
- Direct product cost
- Freight expenses
- Warehousing expenses
- Storage costs
- Sales tax
- Product packaging cost
- Labeling expenses
› Cost of Goods Sold Formula for Manufacturers
If you are a manufacturer, COGS can be quite complex and vast. From raw materials to warehouse, everything counts in COGS. Some of the expenses include the following:
- Warehousing costs
- Labor costs for production
- Labor cost for warehousing
- Labeling
- Packaging
- Equipment costs
- Factory overhead
- Building expenses
Now that we know which type of expenses goes into the cost of goods sold (COGS), let’s discover how it is calculated.
» The Cost of Goods Sold Formula
The formula for COGS is quite easy to comprehend and use.
Here is how you calculate it:
COGS = Beginning Inventory + Purchases during the Period - Ending Inventory
Let’s understand it through an example.
» The Cost of Goods Sold Example
Presume you have a business and are starting the second quarter of the financial year with $30,000 as the beginning inventory. During the quarter, you make purchases worth $10,000. At the end of the quarter, you have $5000 worth of inventory left to be sold.
Now, let’s put these numbers into our COGS formula to get the cost of goods sold for your second quarter:
COGS = $30,000 + $10,000 - $5000
Your second quarter COGS, in this scenario, would be $35,000.
In other words, you spent $35,000 on the products you sold during the second quarter.
Please note that it is a generic example for calculating the cost of goods sold. Your COGS would vary based on the type of your business. And as we explored above, the items you can include in COGS depend on the nature of your business. Therefore, working with an expert accountant makes sense. Doing so would ensure accuracy and the right way of handling COGS.
The good thing is that there are many inventory management software tools out there. Besides offering inventory tracking and management, these tools also let you monitor your production costs and purchases, streamlining your COGS process.
» Which Businesses Don’t Need The Cost of Goods Sold (COGS)?
Businesses that are into making and selling goods can utilize COGS for deductions.
But what about the companies who provide services instead of goods, you ask?
Well, these companies don’t have anything to do with COGS. There is no inventory. No production cost. No products on the shelf or warehouse to sell. And hence, the cost of goods sold would come to be zero.
Such types of businesses are purely service-based entities. Here are a few examples of these service provider companies:
- Accounting firms
- IT services companies
- Law firms
- Artists, such as professional singers and dancers
- Business consultants
While these businesses may have their own expenses for providing services, such costs don’t come under the umbrella of the typical COGS deductions.
» Limitations of the Cost of Goods Sold
Keeping track of COGS is beneficial for businesses since it can help optimize their operations to achieve their ultimate revenue goals. However, maintaining the cost of goods sold comes with its own set of challenges. One can manipulate the numbers and under-report or over-report COGS to paint a false picture of the financial standing of a business.
Some of the COGS limitations include the following:
- Overstating discounts
- Reporting higher overhead costs than what’s actually incurred
- Recording false inventory at the start or end of a given period
- Inflating in-stock inventory value
- Manipulating inventory write-offs
- Reporting exaggerated returns to vendors
With manipulated COGS, it is easier to create a misinterpreted image among the investors, shareholders, and the market at large. Doing so can show a wrong gross profit and thus, a misleading net income.
» Conclusion
The cost of goods sold (COGS) is an integral part of your business finances if you’re into selling goods and finished products. The COGS calculation can be tricky initially but you can rely on trusted inventory management systems and experienced accountants to make the ride smoother. With COGS, you can track your business expenses and optimize the same to cut process costs. Furthermore, you can measure your business profitability more efficiently. What’s more? COGS deductions can also help control the taxable income. Having correct COGS data can not only help you determine your current financial position but also strategically plan for your future business growth.
