The cost of goods sold uses direct costs such as material, labor, and factory overheads to produce the product you sell. The cost of goods sold may consist of variable and fixed costs in manufacturing and selling the products. The cost of goods sold does not include any indirect costs and the cost of making those items that are not sold.
The cost of goods sold is shown in the income statement, which comes under the Sales revenue. The Cost of goods sold is then deducted from the Revenues resulting in Gross Profit.
The cost of goods sold, also known as COGS, is included in the income statement or profit and loss statement, the business/company’s financial report. COGS is treated as a business expense.
In this article, we will discuss the Cost of goods sold and how it works that might help you know about this term and could be beneficial for your business.
Here’s what we will cover:
- What’s the purpose of knowing about COGS?
- What costs are included in COGS?
- The formula for calculating COGS
- Example of COGS
- Inventory Costing Methods
What’s the purpose of knowing about COGS?
There are some reasons why a business should know about COGS, and that’s why we are here to help you. The primary purpose of the cost of goods sold is to help businesses learn about their performance. The following are some other purposes:
COGS and Pricing:
Setting prices for a product that a business sells is a complicated and crucial process. A company can gain profits by doing the right prices of a product.
COGS helps you in setting the right price that may result in healthy profit gains. For example, a company has calculated the cost of goods sold for product B, which is $30; then the company must set the price above $30 to gain profits.
COGS and Taxes:
COGS in taxes is an essential factor, as the cost of goods sold is a business expense for which a business can receive a tax return. Every company/business has to determine COGS because it is an obligation to file an income tax return.
A company should use a proper and accurate accounting method to calculate the right amount of goods sold to prove while filing tax. ‘The lesser the COGS, the higher profits,’ if a company has higher COGS, then it should focus on minimizing it because the higher cost of goods sold results in fewer profits.
COGS and Business Profits:
The cost of goods sold helps you determine the gross profit a business earns without reducing other expenses and taxes. After calculating the gross income or profit, you can subtract all other expenses and determine the net income as a result.
What costs are included in COGS?
Cost of goods sold includes direct costs related to the products you are selling:
- Cost of products for sale or raw materials, including freight
- Storage of products, raw materials, or parts used in production.
- Direct labor costs (including contributions to pensions or annuity plans) for workers who produce the products
- Factory overhead and warehouse costs.
Cost of goods sold doesn’t include indirect costs, including:
- General overhead costs for areas of your business are not related to the production or storage of products.
- Cost of managers and administrative employees.
These costs are considered while calculating COGS, according to The Balance.
The formula for calculating COGS:
There are two methods used in finding the cost of goods sold, which are as follows:
- The formula used for calculating COGS for the accounting year:
Cost of Goods Sold = Beginning Inventory + Inventory Purchases made that year – Ending Inventory.
COGS is calculated yearly, so the following year’s beginning inventory was the previous year’s ending inventory. Inventory purchases are those a business makes for making the product or purchasing a product for selling purposes. Then Ending Inventory is subtracted because these are those items or products that the company/business could not sell and are left in the stock.
The yearly calculation of the cost of goods sold helps a company check for what amount of products it has sold for the year.
- The second method used for finding the cost of goods sold is by looking at the inventory, e.g., in company A, 300 units are made or purchased for sale, and inventory increases by 100 units. The cost of goods sold will be 400 units. But if the company has a decrease in inventory of 100 units, then the cost of goods sold will be 200 units.
Example of COGS:
We take an example of a clothing company for fiscal year (FY) ended in 2018. The clothing company will calculate the cost in the following way:
- Beginning inventory is taken as the inventory recorded in 2017 = $10,000
- Ending inventory will be the one recorded at the end of 2018 = $8,000
- Inventory purchases made for the year 2018 = $18,000
$10,000 + $18,000 – $8,000 = $20,000
We say that the COGS for the fiscal year 2018 is $20,000 for the clothing company. Now that the cost of goods sold is calculated, the company can also find its gross profit by subtracting the COGS from the revenues.
Inventory Costing Methods:
A company uses Inventory costing methods to determine the value of the cost of goods sold. There are three kinds of inventory costing methods that help keep track of the level of inventory a business retains.
FIFO means First In First Out. The products that are made or purchased at their earliest would be sold first, which states that the least expensive product available in the stock will be sold as prices rise over time. The companies that use the FIFO method tend to lower the cost of goods sold than LIFO, and their net income increases over time.
LIFO means Last In First Out. The final products that are made or purchased are sold, and so goods with higher costs are sold with rising prices that may also result in higher cost of goods sold. In LIFO, it also affects the net income to decrease over time because of higher COGS.
Average Cost Method:
Regardless of the date of purchase or when the product was made, the average cost is calculated per product/item. The average cost calculated over some time reduces the high impact on the cost of goods sold.
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