Understanding Cost of Goods Sold

To ensure that you are profitable, it is important to understand how the cost of goods sold (COGS) can impact your overall accounting and sales. This Legal Kitz blog will take you through what is the Cost of Goods Sold, the calculation and the different methods used for calculating COGS.

What does Cost of Goods Sold mean?

Cost of Goods Sold (COGS) is a term used in accounting and finance to describe the direct costs associated with producing and selling a product. It is the cost of the raw materials, direct labor, and overhead expenses required to manufacture and deliver a product to the customer. Cost of Goods Sold is important for businesses to understand because it helps determine the profit margin, which is an indicator of your financial performance. COGS excludes indirect costs such as marketing and distribution costs. 

How to calculate Cost of Goods Sold?

The formula for the Cost of Goods Sold calculation is:

COGS = (Beginning Inventory + Purchases) – Ending Inventory, where

  • Beginning Inventory refers to the value of the goods that a business has on hand at the start of an accounting period. 
  • Purchases refer to the cost of goods purchased during the accounting period, including shipping and handling costs, taxes, and other indirect costs. 
  • Ending Inventory is the value of goods that a business has on hand at the end of an accounting period.

Here’s a quick example. Let’s say your inventory at the beginning of the year was $30,000, by the end of the year you are left with $6,000 and your business made $8,000 worth of purchases. 

Based on the formula, your Cost of Goods Sold should be;

COGS = ($30,000 + $8,000) – $6,000
COGS = $32,000

What are the accounting methods used?

The cost of goods sold (COGS) is an important financial metric that represents the direct costs associated with producing and selling a product. There are several methods used to calculate COGS, including:

  1. First-In, First-Out (FIFO): Under this method, the first items to be purchased are assumed to be sold first, and the latest items to be purchased are assumed to be still in inventory.
  2. Last-In, First-Out (LIFO): The opposite of FIFO, this method assumes that the latest items purchased are sold first and the oldest items remain in inventory.
  3. Average Cost: This method calculates the average cost of all the items in inventory and uses that average cost to determine the cost of goods sold.
  4. Specific Identification: This method assigns specific costs to specific items that have been sold. It is typically used for high-value items, such as works of art or rare collectibles.

The method used to calculate COGS can have a significant impact on the financial statements of a business, and companies must choose the method that best reflects their inventory practices and provides the most accurate representation of their financial performance.

The benefits of understanding COGS are numerous

Improved cost management: Knowing the COGS helps businesses to better understand their costs and make informed decisions about pricing and inventory management. This can help to improve overall profitability by reducing the cost of goods sold and increasing revenue.

Improved budgeting: Understanding COGS is essential for preparing an accurate budget. This information helps businesses to determine the amount of money that must be set aside for inventory purchases, and can help to identify areas where cost-cutting measures can be implemented.

Better planning: Knowing the COGS can help businesses to plan for future growth by allowing them to determine the feasibility of expanding their product line, entering new markets, or investing in new technologies.

Better decision-making: Understanding COGS is essential for making informed decisions about product development, marketing, and sales. It can help businesses to identify areas where they can improve their operations, and to determine the most cost-effective way to bring new products to market.

Improved financial performance: Understanding COGS can help businesses to improve their overall financial performance by reducing costs and increasing profitability. This information is particularly important for businesses that operate on thin margins, as small reductions in COGS can have a significant impact on their bottom line.

In conclusion, Cost of Goods Sold is a critical component of a business’s financial performance and by understanding COGS, businesses can improve their overall financial performance and achieve their long-term goals. You can also find more information on how to sell your product or service, import or export goods and locate a supplier here.

What are the disadvantages of using Cost of Goods Sold?

Cost of goods sold (COGS) is a widely used financial metric, but it also has some disadvantages, including:

  1. Limited Relevance: COGS only reflects the direct costs of producing and selling a product and does not include indirect costs, such as overhead expenses or marketing costs, which can also impact a company’s profitability.
  2. Inventory Valuation: The COGS calculation can be affected by the method used to value inventory, which can result in different COGS figures based on different valuation methods.

What are examples of Cost of Goods Sold?

Cost of goods sold (COGS) refers to the direct costs incurred in the production of a product or the provision of a service. COGS includes the cost of raw materials, direct labor costs, and direct manufacturing overhead expenses.

Examples of COGS include:

  1. Raw materials: The cost of raw materials such as wood, metal, fabric, or plastic used to make a product.
  2. Direct labor costs: The wages and benefits paid to workers directly involved in the production process, such as assembly line workers, machinists, or seamstresses.
  3. Direct manufacturing overhead expenses: The costs associated with producing a product, such as utilities, rent, depreciation, and maintenance expenses for production facilities and equipment.
  4. Freight costs: The cost of shipping raw materials to the production facilities and the cost of shipping finished goods to customers.
  5. Packaging costs: The cost of packaging materials, such as boxes, bags, and labels, used to package finished products.

It’s important to note that COGS does not include indirect expenses, such as marketing and advertising costs, research and development costs, and general and administrative expenses. These indirect costs are considered separate from COGS and are often referred to as operating expenses.

What is not included in Cost of Goods Sold?

Cost of goods sold (COGS) is a financial metric that represents the direct costs associated with producing and selling a product. However, there are several types of expenses that are not included in the calculation of COGS. These include:

  1. Indirect expenses: Indirect expenses are those that are not directly related to the production of a product, such as marketing and advertising costs, research and development costs, and general and administrative expenses.
  2. Selling expenses: Selling expenses are costs associated with the sale of a product, such as sales commissions, shipping and handling costs, and customer service costs.
  3. General and administrative expenses: General and administrative expenses are those incurred by a company in the course of its business operations, such as rent, utilities, insurance, and legal and accounting fees.
  4. Depreciation and amortisation: These are non-cash expenses that reflect the reduction in value of a company’s long-term assets, such as buildings, equipment, and patents.
  5. Losses from damaged or obsolete inventory: If a company has inventory that is damaged or becomes obsolete, the cost of that inventory is not included in COGS. Instead, it is recognized as a loss on the income statement.

It’s important to note that the exclusion of these expenses from the COGS calculation provides a more accurate picture of a company’s gross profit margin and overall financial performance.

How do I calculate gross profit?

Gross profit is calculated as the difference between a company’s revenue and its cost of goods sold (COGS). Gross profit provides an indication of a company’s profitability before accounting for indirect expenses, such as marketing, advertising, and general and administrative expenses. The formula for calculating gross profit is:

Gross Profit = Revenue – Cost of Goods Sold (COGS)

Here’s an example:

Suppose a company has revenue of $100,000 and COGS of $60,000. To calculate the gross profit, we would subtract the COGS from the revenue:

Gross Profit = $100,000 – $60,000. Thus, Gross Profit = $40,000.

This means that the company has a gross profit of $40,000, which is the amount of revenue remaining after accounting for the direct costs associated with producing and selling its products.

Legal advice

Organising the finances of your business and understanding other related elements can be difficult. Our sister company, Business Kitz, offers a wide range of high quality and cost effective business and legal document templates that can help you keep your finances in order, including the business and accounting kit, and invoice template. If you are seeking any legal advice, Legal Kitz is here to assist you. To arrange a FREE consultation with one of our highly experienced solicitors, click here today, or contact us at info@legalkitz.com.au  or 1300 988 954.