Understanding Cost Of Goods Sold (With Formula And Methods)
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One of the primary goals of any business is to make a profit from the goods sold. To calculate this profit, it is necessary to know the cost of goods sold (COGS) to have a clear idea of how much of the revenue is profitable income. Learning how to find the COGS value can help understand a company's revenue, which is important if you work in business, finance or accounting. In this article, we explain the cost of goods sold, provide the formula for calculating it, list common accounting methods and discuss what is not included in the COGS.
What is the cost of goods sold?
Cost of goods sold (COGS) refers to the direct costs of producing goods that are sold during a stipulated period, usually in one financial year. This does not include the indirect costs, such as the costs involved in distributing the product or sales and marketing costs. It may include the cost of running the factory or machinery that is used for producing the products, raw materials or the associated wages of the personnel. For companies that sell services instead of goods, their COGS may include employee costs. Fixed costs usually do not constitute COGS.
COGS is a cost to the company and features in its financial statement. For calculating the net profit, subtract the COGS from the total net sales. To determine the ideal selling price, it is important for a company to know the COGS. To make a profit, it is crucial to understand all the direct and indirect costs of producing a good before deciding the selling price, which is higher than the total costs to add a profit margin. If they cannot sell it at a higher price, then it may not be profitable.
How to calculate COGS
The process of calculating the COGS can vary depending on the costs associated with the sales of those goods. This can be as complex as the manufacturing process and the variations of products that the company sells. Calculating the COGS helps companies file for tax returns as this figure gets deducted from their total sales.
The basic formula for calculating COGS is:
Cost of goods sold = beginning inventory costs + additional inventory costs - ending inventory
Here are the general steps you can take to calculate the COGS:
1. List out the direct costs
Direct costs are costs that relate to the production of a good or service. All the direct costs connected with the production, acquisition and sales of a product are part of the COGS. This means anything the company uses to produce the item is part of this cost.
This may include the cost of raw materials, packaging and inventory, machinery and facility expenses. For example, a t-shirt manufacturing company may spend on the material or fabric, such as polyester, printing machine and colours. All these are going to be part of the direct costs of producing a t-shirt.
2. Find out the indirect costs
Indirect costs are often called overhead or fixed costs. Regardless of the volume of goods being sold, these costs might mostly remain fixed and unchanging. Fixed costs may include salaries of factory workers, rents, warehousing facilities, electricity and other expenses. For example, regardless of how much a company sells in one period, it typically pays the same rent for the building.
3. Determine the costs of the facilities
These are the fixed costs associated with the facilities that are used for production purposes, such as the rents, mortgage interest, warehousing facilities, manufacturing units and other costs. If you overlook these expenses, the calculation may provide an erroneous profit margin. This is why it is important for accountants to consider these expenses carefully.
4. Determine the beginning inventory
For tax calculations and returns, businesses calculate COGS each financial year. The inventory at the end of a year comprises the inventory at the beginning of the next year. This inventory includes any leftover or unsold merchandise, unused raw materials, unfinished products and other supplies that are used in the manufacturing process.
5. Consider the costs of added inventory
The inventory at the beginning is only the start. It is going to grow from there and increase during the year as the company continues to produce and sell more products. This is why it becomes necessary to account for the costs of manufacturing and shipment of each inventory item. For those products that are directly manufactured by the company, the accounting department calculates the cost of each item. This may vary depending on the materials used, facilities costs and time required for production.
6. Calculate the ending inventory
Just as there is a beginning inventory at the start of a tax year, there is going to be an ending inventory as it changes through the course of the year. This ending inventory comprises all the leftover products and materials but excludes any damaged items or those products that are not sellable. The value of these damaged goods gets deducted from the inventory.
7. Calculate the COGS
The final step is calculating the COGS during the financial year. To find the COGS, you require the values of the beginning inventory, any inventory that you added during this period and the ending inventory. You can use this formal to help you:
COGS = beginning inventory costs + additional inventory costs - ending inventory
Different companies may use different costing methods to calculate their COGS. This can make the COGS value vary slightly. If you are considering an accounting career, it is helpful to learn about the different methods. The three main costing methods include:
1. First in, first out (FIFO)
In the FIFO method, companies sell the goods that are manufactured first. As prices increase over a period, using the FIFO method means the company sells the products with the least cost first. This may mean selling products with a higher profit margin first. Here, as the COGS recorded is lower, the tax returns may also be less.
2. Last in, first out (LIFO)
The LIFO method means that companies sell the most recently manufactured or acquired goods first. When prices increase, companies may sell goods at higher costs, thereby increasing the COGS. This lowers the net income over time.
3. Average cost method
This method uses the average cost of all goods, regardless of the date of purchase or manufacture. Averaging out the cost of goods over a period makes it easier to calculate and also prevents extreme fluctuations because of the outliers. As a result, the COGS remains more or less within a similar range throughout the period.
Special identification method
This is a more precise method that uses the exact cost of each product or item sold within a period. With this method, it is possible to know the price of the exact item sold and the costs of manufacturing or purchasing it. This is the preferred method used by companies that sell unique or precious items like real estate, gems, jewellery and cars.
Exclusions from COGS
With companies that produce physical goods, COGS can be easier to calculate, but it can get complicated with companies that primarily or exclusively sell services. COGS may be difficult to calculate or may even be absent in some cases. For example, a company providing web development services may not have any COGS, but they do pay their employees or developers a monthly salary. The salaries are usually a fixed expense for the company, but the sales can vary every month. Such companies usually lack an inventory. As a result, they may be unable to record COGS in their income statement.
Business consultants, law firms, real estate agencies, digital marketers and accounting firms are some examples of purely service-based industries that do not stock any inventory of physical goods. Undoubtedly, these companies do incur costs for providing their services, but these costs do not constitute COGS. Rather, they are called cost of services. This does not give them a COGS deduction. COGS also does not include salaries and other administrative costs. Companies may include certain labour costs in COGS if they can directly relate them to the production of specific goods.
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