If you’ve been hanging around the accounting department, chances are you’ve heard the term cost of goods sold (COGS) thrown around a few times. But while COGS is important, it’s also a concept people tend to misunderstand.
Knowing what COGS is will help you better understand all of the costs associated with your product and your profit margins. In this article, we’ll go over this common accounting term, including what it is, and how to calculate yours.
What is the cost of goods sold?
Cost of Goods Sold (COGS) refers to the cost of producing the goods that have been sold by a business. COGS is classified as an expense account on your income statement, representing the amount you have to recover from each sale to break even before bringing in profits.
COGS is only recognized upon the sale of inventory and is reported in the financial period in which those sales occur. For example, let’s say you have a clothing business with $5,000 worth of inventory. If you sell $2,500 worth of that inventory in the second quarter, you would record $2,500 in COGS. The rest would continue to stay in your inventory account.
As you can see in the example, the cost of inventory sold and COGS match. That’s because the value of your inventory stems from the direct costs of the items that make up that inventory, whether you’ve bought the materials to manufacture the items or purchased them for resale.
It also includes additional charges directly related to preparing products ready for sale, like packaging and delivery charges.
So, if we go back to the clothing store example, the $5,000 inventory number doesn’t come from thin air — the total includes the cost of the fabric, labor, packaging materials used, and delivery fees.
However, note that COGS excludes indirect expenses such as sales and marketing, so the costs associated with trying to sell t-shirts or jeans wouldn’t factor into the overall calculation.
Put simply, COGS equals the direct cost related to producing or purchasing products sold. Beyond that, just remember that the value of your inventory on hand is considered an asset until the inventory is sold.
Why is it important to calculate the cost of COGS?
Most businesses are in it to be profitable, and calculating your COGS is an important step to getting in the black. When you know your COGS, you can work to reduce the costs associated with selling, including the cost of your inventory.
COGS informs a business about the direct expenditures incurred in getting products ready for sale. For instance, if you know t-shirt fabric costs $5/yard, the labor to sew the shirts is $15/hour, and an average of $1 is spent on packaging each item, you can accurately price your t-shirts at a point where you can profit off the sale.
In this case, setting the t-shirts at $15 wouldn’t make you any money. Assuming each t-shirt uses two yards of fabric and takes 30 minutes to make, you need to price the t-shirts at $30 or more before you can even see a small profit.
Seriously, calculating COGS can make or break your business. Here are some of the other benefits of calculating COGS:
1. Helps create a pricing strategy
As demonstrated above, you can determine your selling price by knowing the direct costs incurred in producing or procuring products. Once you know these costs, you can figure out how to price your products to also cover your indirect expenses and earn a profit from the sale. But if you don’t know your COGS, you are honestly just guessing.
Overall, knowing COGS helps you determine how much profit margin you can keep on the products you sell.
2. Helps determine the total expenses incurred in selling products
Your profit and loss statement needs to list all your income and expenditures. By calculating the direct costs you have spent acquiring your stock, you can arrive at the total expenses incurred by including indirect expenses like your overhead, sales, and marketing costs.
You also need to know COGS before calculating your Inventory Turnover Ratio, which can help you make more informed decisions regarding your inventory and cut expenses further.
For example, if you calculate your inventory turnover ratio and find it’s pretty low, you’ll know you don’t need to replenish your inventory as often. That, in turn, means you can negotiate better deals with suppliers to further reduce costs.
3. Compare the market value of your product with your competitors
Determining profit margin by only considering direct costs incurred is an incomplete picture. If your prices are higher than your competitors you may make fewer sales.
If your prices are lower than your competitors, you can still incur a loss since your low profit margin might not cover your indirect expenses. COGS helps you to sell your product at a competitive price, grow sales, and, by extension, earn profits.
Now that you know the importance of calculating COGS, let’s learn the formula to calculate COGS.
How to calculate COGS
Here’s the formula to derive COGS:
COGS = Beginning Inventory + Purchases made during the period – Ending Inventory
To calculate the COGS for a reporting period, start with the value of the beginning inventory. If additional inventory was added during the reporting period, be sure to add the value of any new inventory produced or purchased to the value of the existing stock. Now, subtract the value of ending inventory from COGS sold for that reporting period.
Note, that this is a basic formula and does not take into account items like returns, discounts, obsolete stock, and the inventory valuation method used. It’s still really useful, however, as shown in our breakdown below.
Example of COGS
Let’s assume that company X uses the calendar year to record their inventory. The beginning inventory value was recorded on the 1st of January, and the ending inventory value was recorded on the 31st of December.
The beginning inventory value was $20,000. During the year, the retailer realized that the business would sell more than the inventory received earlier in the year, so additional inventory worth $7,000 was purchased. At the end of the calendar year, the ending inventory value was worth $4,000.
Now, let’s work out the COGS for the entire year by using the following formula:
COGS = Beginning Inventory + Purchases made during the period – Ending inventory
COGS = $20,000. + $7,000 – $4,000.
Therefore, COGS = $23,000.
The COGS equals $23,000, as calculated. Use this formula to help with production, purchasing, and pricing decisions.
Calculating COGS can also help you calculate your profit for a reporting period and help with decisions to ensure that indirect costs are covered.
Suppose your revenue is $75,000 in a reporting period. Knowing the COGS, you can determine your profit will be $75,000 – $23,000 = $52,000.
COGS – Key business takeaways
The COGS formula can be used at an individual product level to help with decision-making before producing, procuring, and selling that product. It can help you make decisions like how much inventory you need to purchase or whether you might need to focus on marketing a slow-selling product, and it’s useful when tax season rolls around, too.
The COGS for a reporting period is the total COGS for all product sales for that reporting period. It is a vital metric included in your financial statements and used to calculate your gross profit for that reporting period.
Gross profit is a profitability measure that shows how well a business can cover its indirect expenses and earn a profit. The value of COGS will always depend on the direct costs of the products sold and the inventory valuation method used by the business.
Frequently asked questions
What is the difference between COGS and expenses?
COGS is a measure of the expenses associated with selling your goods. In particular, the direct expenses like labor, manufacturing, and materials. It does not include indirect expenses like rent or general office materials.
Is the cost of goods sold the same as profit?
No. The name cost of goods sold gives you a hint that COGS covers some of your expenses. However, you can figure out your profit if you know your COGS. To do that, use the following formula:
Revenue – Cost of Goods Sold = Gross Profit.
Remember, COGS tells you how much your items cost to make and sell; profit is how much you keep after these expenses.
Is the cost of goods sold taxable income?
In general, the IRS allows businesses to deduct some COGS-related expenses. For example, the IRS states you can include some business expenses in your COGS, which you subtract from your revenue to arrive at your gross profit (your taxable income).
If you calculate this way, you are not allowed to deduct those expenses a second time as a business expense!
COGS is a big part of running a profitable business, and your inventory is a big part of COGS. To keep track of it all, you should invest in a cloud-based inventory and order management system like Cin7.
When you add in an inventory management system, you have a much clearer view of how to address any slumps, slow-downs, or sales. Working with Cin7 can help your business hold onto less while making more. Request a demo today.
