Cost of Goods Sold (COGS): Definition, Calculation, & Formula
Cost of Goods Sold (COGS): Definition, Calculation, & Formula
You may have come heard the term Cost Of Goods Sold from your accountant or thrown around at a corporate meeting.
If you’ve ever wondered "what is Cost of Goods Sold and whit is it important?" then this article is for you.
What is Cost of Goods Sold?
Let’s first understand the term Cost of Goods Sold. In accounting, the term Cost of Goods Sold (COGS) refers to the direct cost of the production of the goods or products sold by a company. This amount includes the additional material charges as well as those used for the delivery and packaging of the goods. This includes COGS computation and COGS calculation.
However, it excludes indirect costs such as sales & marketing.
COGS vs Cost of Revenue
While COGS includes the direct costs of producing physical goods—like raw materials and labor—Cost of Revenue takes a broader view. It includes COGS plus other expenses tied to delivering a product or service, such as shipping or sales commissions. For businesses offering both products and services, understanding this distinction helps clarify margins. COGS affects gross profit, while Cost of Revenue helps capture total delivery cost, but both can sharpen your financial strategy and highlight areas to improve efficiency.
COGS vs Operating Expenses
COGS reflects the cost of creating your product—materials, labor, and production. These costs vary with sales and directly impact gross profit. Operating expenses (OPEX), on the other hand, are fixed or recurring costs tied to running your business—like rent, software, or marketing. They appear lower on the income statement and affect operating income. Separating these helps you see where money is going. If your gross margin is strong but profits are low, OPEX could be the area to optimize.
Why is it Important to Know and Calculate the Cost of Goods Sold?
COGs are an important part of a business’s finances, impacting the gross margin, net income, and cash flow. Here are some of the benefits of knowing Cost Of Goods Sold (COGS).
Informs a Smarter Pricing Strategy
Reveals Your True Product Costs
Supports Competitive Market Positioning
How to Calculate the Cost of Goods Sold
The Basic COGS Formula
The basic Cost of Goods formula is as follows:
COGS = Beginning Inventory + Purchases made during the period – Ending Inventory
To calculate your total annual inventory spend, you always start with your beginning inventory—the stock you had at the start of the year. Then, you add any new inventory purchases made throughout the year. Finally, to figure out how much inventory was actually sold, you subtract your ending inventory. This gives you a clear picture of the goods that moved through your business and is a key part of calculating your Cost of Goods Sold.
An Example of the COGS Formula in Action
Let’s assume that ‘x’ business uses the calendar year to record its inventory. Now, the beginning inventory was recorded on 1st January, and the ending inventory was recorded on 31st December.
The beginning inventory cost was $20,000. During the year, the retailer realized they needed an additional $7,000 worth of inventory, so they made a purchase. By the end of the year, the ending inventory was valued at $4,000. Now, let’s calculate the Cost of Goods Sold for the entire year using our formula.
COGS = Beginning Inventory + Purchases made during the period – Ending Inventory
COGS = $20,000 + $7,000 – $4,000
Therefore, COGS = $23,000.
The cost of goods sold equals $23,000, as calculated. This figure will help you make fair decisions, choose vendors with direct material prices, and manage your operating expenses and orders.
Calculating the COGS can also help you calculate your yearly gross income. Suppose your annual revenue is $75,000.
Now, with the cost of goods sold statement in your hands, your gross income will be $75,000 – $23,000 = $52,000.
FEFO vs FIFO vs LIFO: Key Inventory Management Methods
When managing inventory, businesses can adopt different methods to determine how inventory is valued and sold. The choice of inventory management method directly impacts the COGS and, consequently, profitability. Understanding the differences between FEFO, FIFO, and LIFO is crucial for making accurate financial decisions.
What is FEFO?
FEFO (First Expired, First Out) is an inventory management method that ensures products are sold in the order of their expiration date. This approach is commonly used for perishable goods such as food, pharmaceuticals, and cosmetics. By prioritizing products with the earliest expiration dates, FEFO helps reduce waste and avoid selling expired items. This can also result in more accurate financial reporting and efficient inventory turnover.
What is FIFO?
FIFO (First In, First Out) is an inventory method where the oldest inventory items are sold first. This is ideal for products that have a shelf life or are subject to market changes, like electronics or fashion items. FIFO ensures that your company is using older inventory before newer items, preventing the obsolescence of older stock and optimizing the use of available materials. In terms of COGS, FIFO tends to result in lower costs during periods of inflation, as older, cheaper inventory is sold first.
What is LIFO?
LIFO (Last In, First Out) is the opposite of FIFO. Under this method, the most recently purchased or produced inventory is sold first. LIFO is commonly used in industries where prices are rising, as it helps reduce taxable income by matching the most recent, higher-cost items with sales. However, LIFO may not always reflect the actual flow of goods and can lead to outdated inventory valuation on financial statements. When it comes to COGS, LIFO often leads to higher costs during inflationary periods, reducing taxable income and improving cash flow.
The Role of Inventory Management in COGS
Effective inventory management rules are crucial in managing the Cost of Goods Sold. By optimizing inventory levels, businesses can reduce operating expenses and improve their gross profit margin. Proper tracking of COGS involves regular monitoring of inventory purchases, closing inventory, and production costs to ensure that COGS remains as low as possible.
How Optimized Inventory Reduces COGS
By maintaining accurate inventory levels and implementing efficient inventory accounting methods such as the average cost method or the special identification method, businesses can avoid overstocking and reduce overhead costs. This reduction in excess stock directly impacts COGS, leading to lower COGS and higher profitability. Businesses should also leverage accounting software for precise COGS calculations and inventory tracking, ensuring real-time updates and adjustments.
The Impact of Inventory Turnover on COGS
A high inventory turnover rate indicates that goods are being sold quickly, which often results in lower holding costs and a more favorable COGS. Conversely, low turnover may lead to excess inventory, increasing operating expenses and resulting in higher COGS. Businesses should strive to balance inventory to maximize their gross margin while minimizing their COGS.
Cost of Goods Sold: Key Business Takeaways
Understanding how COGS works helps you price your products strategically, manage margins, and maintain financial health. Here’s a summary of the most important points to keep in mind:
- The COGS is a vital metric as it is the only figure that gets subtracted from the business revenue to get its gross profit. The gross profit is a profitability measure that shows how well a business can manage its labor and supplies in the production process, including its inventory purchase and fixed costs.
- The value of COGS will always depend on the accounting standards that are used in the calculations, such as the average cost method or the special identification method.
COGS in Different Business Models
COGS can vary significantly depending on the business model. Understanding these differences is essential for accurate financial modeling and COGS computation.
Retail Industry
In retail, COGS primarily includes the cost of goods purchased for resale. Retailers must carefully manage their inventory purchase and monitor closing inventory to avoid higher COGS. Using the COGS formula, retailers can calculate the cost of their goods sold and make informed pricing and purchasing decisions to improve net income and cash flow.
Manufacturing Industry
For manufacturers, COGS encompasses production costs, including raw materials, labor, and fixed costs. Accurate COGS accounting in manufacturing requires tracking the cost of goods manufactured and considering overhead costs related to production. Optimizing these elements can lead to a more accurate reflection of true COGS and better financial performance.
Service Industry
In the service industry, COGS may differ as it often includes the cost of labor and materials directly tied to delivering services. While there may not be physical inventory, managing operating expenses and optimizing resource allocation is key to maintaining a low COGS. Effective financial modeling helps service businesses track and reduce their COGS, thereby enhancing profitability.
Take Control of Your COGS with Cin7
Understanding Cost of Goods Sold is essential for maintaining healthy profit margins and making smarter financial decisions. Knowing what goes into COGS gives you a clearer picture of your business performance.
With Cin7, you don’t have to calculate COGS in the dark. Our platform connects your inventory, sales, and supply chain data in real time—so you always know your true product costs, whether you use FIFO, FEFO or another specialized costing method. Ready to gain clarity and control over your margins? Let Cin7 help you make cost-based decisions with confidence.