Businesses must keep account of all direct costs associated with preparing goods for sale, including labor and material costs. These expenses are referred to as the Cost of Goods Sold (COGS), a computation that appears on a company’s Profit and Loss statement (P&L).
COGS is also a crucial component of tax return information since who doesn’t want to claim the correct tax deduction? Knowing how to calculate COGS can help you set the right pricing for your goods, identify growth prospects, and manage your taxes. In this lesson, we will focus on how to calculate the Cost of Goods Sold utilizing its formula.
What is the Cost of Goods Sold (COGS)?
The cost of goods sold is the direct cost of inventory sold by a company over a given period. It comprises all costs that are directly related to the items or services sold during a given week, month, or year. However, it does not include any indirect or fixed costs such as overhead or marketing; it is simply the cost of purchasing or manufacturing goods sold in a specific timeframe.
Formula and Calculation of Cost of Goods Sold (COGS)
While the cost of products sold is concerned with cost, the metric is determined in an indirect manner. COGS is computed by comparing the costs of beginning and ending inventory and then adding the cost of inventory acquired and sold within the covered period, rather than immediately totaling the cost of goods sold by totaling expenses. In other words, the formula prioritizes time rather than money.
COGS = Beginning Inventory + Purchases – Ending Inventory
Of course, if you handle your own manufacturing, the COGS formula becomes a little more complicated. In that situation, the cost of creating the inventory would be the starting inventory.
Purchases represent the direct cost of producing more things during the time, whereas Ending Inventory represents the direct cost of unsold commodities.
Extended COGS Formula
It’s a more detailed formula that takes into account things like returns, freight expenses, discounts, and allowances. As a result, the extended COG formula is:
COGS = Beginning inventory + purchases + Freight In – Ending inventory – Purchase Discounts – Purchase Returns and Allowances.
- Beginning inventory: Beginning inventory is the amount of inventory at the start of the stock period.
- Purchases: all costs incurred for purchasing produced goods or establishing a product, such as raw materials.
- Freight In: the transportation charges for bringing raw materials to the setup location or plant.
- Ending inventory: the amount of merchandise remaining at the end of the defined time.
- Purchase discounts: Purchase discounts are discounts received across the product supply chain.
- Purchase returns and allowance: Purchase returns and allowances are expenditures spent when things are returned to suppliers. Meanwhile, allowances are any extra benefits gained within the product’s purchase chain.
Consider the corporation XYZ, which produces pen packs. The direct cost of producing one packet is £2.00, and the other statistics are listed below.
- Opening inventory: 3000 packets
- Closing inventory: 1,000 packets
- Freight in £20,000
- Discounts received: £4,500
- Purchase costs: £50,000
Solution
The cost of opening inventory: 3000 x 2 = £6,000
The cost of closing inventory: 1000 x 2 = £2,000
COG= £6,000 + £50,000+ £20,000-£4,5000 – £2000 = £69,500.
Cost of Goods Sold Examples
Let us look at some examples and demonstrate how the cost of products sold can be determined using its formula:
Example #1
Assume you wish to figure out the cost of products sold in the first quarter of 2021. The initial inventory date for your inventory record will be January 1 and will terminate on March 31. If your company had a £20,000 beginning inventory, £9,000 in purchases for that quarter, and a £5,000 ending inventory, your total COGS for that quarter would be:
COG= Beginning Inventory + Total Purchases on the Specified Period – the Ending Inventory
COG= £20,000+ £9,000 -£5,000 = £24,000
Therefore, the total costs of goods (COG) sold in that quarter were £24,000.
Example #2
The starting inventory for the fiscal year ending in 2020 is £3,000. Additionally, extra inventory was purchased during the 2020-2021 fiscal year, totaling £2,000, with £1500 of ending inventory recorded at the close of the fiscal year in 2021. The cost of goods sold will be calculated using the COG formula as follows:
COG = £ 3,000 + £2,000 – £1,500 = £3,500.
A cost of goods sold (COGS) spreadsheet is an example.
Tips for Calculating COGS
Calculate the direct and indirect costs. You must distinguish between the two because indirect costs must be excluded from your estimates. Salaries, rent paid on the facility where the business’s manufacturing activities take place, and even the depreciating worth of instruments used in the manufacturing process are all examples of indirect expenses.
Discover the initial inventory. If your company calculates COGS on an annual basis, the beginning inventory of each year should be the same as the ending inventory of the previous year.
COGS and Inventory Accounting Methods
While there is only one formula for calculating the cost of products sold, businesses can pick from a variety of accounting procedures to determine their specific cost. Each approach is a unique means of determining the cost of individual things sold over a specified time period.
In practice, at least four accounting methodologies exist for calculating COGS. Companies are free to select any of these, but they must be consistent once they do. And, while it can be tough for businesses to decide, the method they adopt can have a significant impact on profitability as well as tax implications.
Let us investigate these methods:
#1. First In, First Out (FIFO)
First in, first out (FIFO) is an accounting system that assumes that when a corporation makes a transaction, the inventory that has been on hand the longest gets sold first. So, if a company paid £5 per unit a year ago and now pays £10 per unit when it sells, COGS per unit is £5 until all of its year-old units are sold.
While FIFO has advantages for some firms (such as making it easier to monitor inventory turnover), it can also result in increased tax obligations if a company’s inventory costs are continually rising.
#2. Last In, First Out (LIFO)
The method of last in, first out (LIFO) deems the most recently purchased items in a company’s inventory to have sold first. So, if a company spent £5 per unit a year ago and now spends £10 per unit, the COGS per unit is said to be £10 until all of the company’s more recently purchased units are sold.
LIFO can provide significant tax benefits to firms, particularly those with big and valuable inventories. However, if a corporation dramatically reduces its inventory in a given period and sells some of its “cheapest” inventory, and prices have grown since the inventory was obtained, this can result in exorbitant tax payments for that year.
#3. Average
The averaging approach of calculating COGS does not take into account the exact cost of each units. It makes little difference whether or what a company’s inventory expenses fluctuate. Instead, organizations that use the averaging method calculate COGS by establishing an average per unit cost and then multiplying that average by the number of units sold over a given time.
The average technique is significant because it represents a pleasant middle ground between the FIFO and LIFO systems. It’s not the best option for tax purposes, but it’s also not the worst. It’s also relatively simple to apply and maintain.
#4. Special Identification
The specific identification method is an accounting technique that enables businesses to assign exact values to individual units sold within a certain period. This strategy may be suitable for firms that sell custom goods or services, as well as those with inventory that varies greatly in value, such as a shop selling costly antiques.
Without the specific ID mechanism, COGS for enterprises like these would vary greatly depending on what they sold during a given period.
Why Is It Important to Know COGS?
Here’s why you should know your COGS if you own a small business.
#1. Determine the appropriate product pricing
You may establish the correct product cost without offending your customers if you know your COGS. You will be able to successfully pay your business’s operational costs while earning a healthy profit margin if you choose the proper price. In general, you’ll be able to tell whether it’s time to lower or raise your product prices.
#2. Tax Management
Your COGS and your taxes have a direct relationship. It is important to note that sales COGS for your business are tax-deductible. COGS are often the second line item in a company’s income statement. You don’t want to get into legal trouble because you didn’t file your taxes appropriately.
#3. Look for Growth Opportunities
Using COGS on a consistent basis entails analyzing historical data to establish seasonal trends. Using past developments, you can find fresh chances that can propel your company’s growth.
#4. Examine the Health of Your Company
COGS may be used to calculate various ratios, allowing you to easily determine the health of your firm. As a result, you may make smarter judgments, particularly those that are more likely to benefit your organization.
Limitations of COGS
COGS can be incredibly useful for organizations in monitoring direct expenses and identifying cost-cutting solutions, but it has limitations. COGS does not reflect a company’s total cost of selling because it excludes charges such as marketing. Furthermore, because COGS excludes fixed expenditures, it may not accurately depict a company’s profitability.
COGS also has the following limitations:
- True COGS per unit sold can vary greatly.
- COGS varies according to the volume of sales in each product line.
- COGS may vary throughout periods, even while sales are constant, depending on the accounting technique used by the company.
- Managers must pay close attention to comprehend their COGS.
- The impact of COGS on a company’s profitability is not always obvious.
Cost of Revenue vs. COGS
Revenue expenses exist for ongoing contract services, which can include raw supplies, direct labor, shipping charges, and sales commissions. However, without a physically manufactured product to sell, these goods cannot be claimed as COGS. The IRS website even includes a list of “personal service businesses” that do not include COGS on their income statements. Doctors, lawyers, carpenters, and painters are among them.
Many service-based businesses sell some sort of product. Airlines and motels, for example, are primarily providers of services such as transportation and lodging, but they also sell presents, food, beverages, and other products. These products are unquestionably considered goods, and these businesses undoubtedly have inventory of them. COGS can be listed on income statements and claimed as a tax deduction in each of these businesses.
What Goes into the Cost of Goods Sold or COGS?
These are the direct costs of producing things for sale by your company. COGS covers directly used labor as well as the overall cost of materials needed to manufacture products. This figure also includes other expenditures such as trade and cash discounts, freight-in, and total costs. COGS, on the other hand, excludes any indirect costs, such as sales force expenses or distribution charges.
What are Examples of COGS?
COGS comprise raw material costs, direct labor costs, and manufacturing overhead charges. COGS in a retail business would be the cost of products acquired for resale.
The COGS may include the cost of materials or labor directly related with providing the service in the case of a service business. Also, COGS are essentially any costs directly related to the production or procurement of goods or services sold by the business.
How Do You Calculate COGS from Gross Margin?
The cost of goods sold (COGS) margin is derived by dividing a company’s COGS by its revenue, whereas the gross margin is produced by dividing a company’s gross profit by its sales. Where: Net Revenue – Cost of Goods Sold (COGS) = Gross Profit
What is a Good COGS to Sales Ratio?
The Food Service Warehouse suggests that your restaurant’s cost of goods sold (COGS) not exceed 31% of sales. While fine dining restaurant COGS may be slightly higher due to greater food prices, pizza businesses should strive for COGS in the low to mid 20% range due to reduced running costs.
Is it Better to Have a Higher or Lower COGS?
The lower the cost of goods sold (COGS), the better, as it shows a large profit margin on sales or services. While COGS should undoubtedly be prioritized for financial health, some business models naturally lend themselves to better margins.
Conclusion
The cost of goods sold is the direct cost of manufacturing a good, which includes the costs of materials and labor. COGS has a direct impact on a company’s profits because it is removed from revenue. Companies must manage their COGS in order to increase profitability.
A corporation can be more lucrative if it can cut its COGS through stronger supplier relationships or greater efficiency in the manufacturing process.
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