What is cost of goods sold (COGS)

Saturday, December 05, 2015

An essential metric for business owners

Many small businesses produce goods. Whether your small business is a t-shirt company or a company that makes dog leashes, the cost of producing your product is a major factor when determining your company’s profitability. Therefore, it’s important to understand these costs and how they affect your small business. In this article, we’ll dive into cost of goods sold. We’ll look at what it means, what it includes and how you can calculate cost of goods sold at your business. To start, let’s define cost of goods sold.

What is cost of goods sold?

Cost of goods sold (COGS) is an important metric for your business. This term refers to the total direct cost your business incurs when making your product. Sometimes the cost of goods sold is also named the cost of sales. That’s because it’s a metric that demonstrates all of the costs that go into your product to sell it. COGS does count as a business expense. Here are some of the biggest pieces of COGS for businesses:

  • Raw material costs
  • Items purchased for resale
  • Freight-in costs
  • Purchase returns and allowances
  • Trade or cash discounts
  • Direct labor costs
  • Production part costs
  • Storage costs
  • Factory overhead

As you can see, these costs are directly related to the production of products. To determine if an item is included in COGS, there’s a question you can ask to help you make the determination: If we don’t produce any products, would this cost still exist? If the answer is no, it’s likely part of the cost of goods sold.

There are other costs in your business, and some of these cannot be included in COGS. These costs are general to your business like rent, machinery, administration and marketing. Indirect costs like these are overhead costs or operating expenses, not cost of goods sold. Now that you know more about COGS, let’s look at how understanding your cost of goods sold can help your business.

Why should you calculate COGS?

While it may seem like a tedious process to calculate COGS, getting a number can help you figure out your break even point. This is the lowest point you can sell a product without losing money. You’ll deduct COGS from revenues (sales) in order to calculate gross profit and gross profit margin. Your margin is any amount higher than your break even point. The more margin in your sales, the more money you stand to make and the more successful your business has the potential to be. Without knowing either of these numbers, it’s hard for you to tell if your business is making or losing money. Obviously, this is an important metric to know, especially if you have or are looking to have investors in your business.

There is a standard COGS formula that accountants and bookkeepers use:

Beginning Inventory + Purchases - Ending Inventory = Cost of Goods Sold

In the next section, we’ll learn how to use this formula to calculate cost of goods sold.

How to calculate cost of goods sold

The formula for calculating COGS in a given period seems pretty straightforward, but it’s not that easy. That’s because businesses can calculate their inventory number in a few different ways according to the Generally Accepted Accounting Principles (GAAP). And the value of this number can drastically alter the final COGS number. Therefore, you’ll need to pay special attention to how your inventory method affects COGS. Here are a few of the most common ways:

  • First-In-First-Out (FIFO) – In this method, the earliest goods purchased or manufactured are sold first. Typically, prices tend to go up over time. That means that a company utilizing the FIFO method sells its least expensive products to make first. This results in a lower COGS number than the LIFO method. All in all, it means that net income should increase over time.
  • Last-In-First-Out (LIFO) – In this method, the goods produced or procured most recently are sold first from inventory. That means that goods with higher costs are sold first, and the resulting COGS amount is higher. The net income will decrease with this inventory accounting method.
  • Average Cost Method – The average cost method means that all of the inventory a business holds is averaged during the time period. Total costs of the products in a specific period are divided by the number of products produced in that time period. By taking the average production cost over a given period, this approach can have a smoothing effect on COGS and help to level out any extreme fluctuations.

Let’s look at a quick example of calculating cost of goods sold, assuming we’ve already figured out our inventory cost number.

Beginning inventory (for the period): $20,000

Plus: Purchases or additions to inventory: $30,000

Goods Available for Sale: $50,000

Less: Ending inventory for the period: ($10,000)

Cost of Goods Sold: $40,000

COGS is an important piece of the financial reporting puzzle. Often, you’ll see the calculated COGS on a company’s financial statements. Most specifically, COGS appears on the income statement or profit and loss statement. You’ll also see inventory on the balance sheet. Since the balance sheet only captures a company’s financial health at the end of an accounting period, the inventory value under current assets on the balance sheet is the ending inventory.

As you can see, knowing how to calculate COGS is an integral part of being a successful small business. However, keep in mind that it’s a tedious process and small mistakes can lead to under- or overreporting the cost of goods sold at your business. That can obscure the true metrics of your business and give you a muddled picture of how your business is operating. Therefore, you’ll want to do your best to accurately calculate your COGS or work with professionals to do so.

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