Cost of Goods Sold (COGS): Definition, Calculation, & Formula

What is Cost of Goods Sold? How to calculate it using the formula with Example

You must have come across the term Cost Of Goods Sold or simply called  COGS when you meet your accountant or at a corporate meeting.

If you’ve wondered ever what is it and why is it so much important then this article is for you.

Let’s first understand the term Cost of Goods Sold.

What is Cost of Goods Sold?

Cost of Goods Sold (COGS) is a direct cost of the production of the goods or products sold by a company. This amount includes the additional material charges as well which are 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.

Why is it important to know and calculate the Cost of Goods Sold?

The primary motive of starting any business is to earn a profit. A business person can earn profit only when he knows his exact expenses and incomes by selling his/her goods.

Cost of Goods Sold gives the idea to a business person about their expenditure in procuring the material they want to sell. Therefore, it becomes an important part of their finances, impacting the gross margin, net income, and cash flow. Here are some of the benefits of knowing Cost Of Goods Sold (COGS).

• Helps in creating a pricing strategy
  Firstly, your selling price can be determined by knowing the total expense you have made in procuring the products. Once you know the amount in which you have purchased the product, you will be in a better position to judge the price at which you would like to sell the product so that you can not only cover your expenses but also earn profit from it.
  Hence, knowing COGS helps you in determining how much profit margin you can keep on the products you sell.
• Helps in determining the actual expenses in obtaining the products
  Now, this is more of an accounting thing but none the less it is important. Your income statement needs to list all your expenditures and incomes. So knowing the amount you have spent in getting the products to be sold you can arrive at actual expenses by including other costs incurred in the overhead i.e. sales and marketing.
• Helps in comparing the market value of your product with your competitors
  Once you know the exact purchasing amount and thereafter deciding your profit margin is not an ideal strategy. Chances are that you might have added more profit margin or less in comparison to your competitors in the market. In such a situation, if your prices are high in the market then nobody will purchase your product and you will incur a loss. If the prices are lower than your competitors then also you will incur loss since you are having a low-profit margin.Hence, COGS indirectly helps you in selling your product at the right price that can get you more sales and thereby, also help in earning profit.

Now that you know the importance of calculating the COGS, let’s learn how to calculate COGS using a formula.

The Role of Inventory Management in COGS

Effective inventory management is crucial in managing the Cost of Goods Sold (COGS). 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.

How to calculate the Cost Of Goods Sold using a formula?

So, without wasting any more time, here’s the Cost of Goods Sold formula:

COGS = Beginning Inventory + Purchases made during the period – Ending Inventory

The cost of goods sold equation, although being a bit strange, certainly makes sense.

To calculate the overall annual spendings, you will always have to start from the beginning inventory. There are chances that some new items were introduced in the beginning inventory, so a new inventory that is purchased is added to the old one. Now, as we are to calculate how much of the inventory was sold, subtract the ending inventory.

Example of COGS

Let’s assume that ‘x’ business uses the calendar year to record their 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. While the sales were on, the retailer realized that the business might need an additional inventory worth $7,000. At the end of the calendar year, the ending inventory proved out to be worth  $4,000. Now, let’s try to find the Cost of Goods Sold for the entire year by calculating with 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. Now, this figure will help you with fair decisions, choosing vendors with direct material prices, etc, which also impacts your operating expenses and order management.

As the COGS is calculated, this can also help you to 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.

COGS – the key business takeaways

• The COGS is a vital metric that is displayed on your financial statements 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.
• When talking about an automobile business, there are high chances that the selling figures might fluctuate at the end of the year. There is a tremendous impact on the resale value when it comes to the model of the car, wherein the build-year plays an important role. Because of this, even the COGS varies due to fluctuation in the ending inventory; possibilities of either having an immense profit in the business or vice-versa.
• 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.