Cost of goods sold (COGS) refers to the direct expenses incurred by a company in producing the goods it sells. It’s an essential metric that encompasses the cost of materials and labor directly involved in manufacturing or acquiring the goods.
What is cost of goods (COGS)?
Cost of goods sold (COGS), sometimes referred to as “cost of sales,” represents the direct expenses incurred by a company in the production of goods or provision of services. It includes various elements such as material costs, direct labor costs, and direct overheads, all of which are essential for bringing products to market or delivering services to customers. Depending on your company’s accounting policies, COGS may also include depreciation expenses associated with production facilities and equipment.
However, COGS excludes certain expenses not directly related to production, such as general selling expenses like management salaries and advertising costs. These expenses are categorized separately under selling, general, and administrative (SG&A) expenses.
How to calculate cost of goods sold
This is the formula to calculate cost of goods sold (COGS) over a specific time period:
Beginning inventory + Inventory costs – Ending inventory = Cost of goods sold
Let’s break down each variable:
- Beginning inventory. This represents the inventory value at the beginning of the chosen time period. For instance, if your business started the period with 10 products that cost $100 each to manufacture, your beginning inventory would amount to $1,000.
- Inventory costs. This includes any additional costs incurred for inventory purchased or produced during the specified time frame, excluding the beginning inventory. It encompasses expenses related to acquiring or manufacturing additional inventory.
- Ending inventory. This refers to the value of inventory that remains unsold at the end of the period, the ending inventory reflects the cost of goods that have not yet been sold.
Bear in mind that the method your business uses to account for inventory costs affects how COGS is calculated. Here are the four primary inventory costing methods:
- FIFO (First In, First Out). Under FIFO, the oldest inventory is considered sold first. This method assumes that the first items acquired or produced are also the first to be sold.
- LIFO (Last In, First Out). LIFO assumes that the most recently acquired or produced inventory is sold first. This method reflects the cost of goods sold based on the latest inventory acquisitions.
- Weighted average. This method calculates the average cost of inventory by considering the total cost of goods available for sale and dividing it by the total number of units. It treats all units of inventory equally, regardless of when they were acquired or produced.
- Special identification. Under this method, each individual unit of inventory is uniquely identified, often through serial numbers or other tracking mechanisms. This allows for precise tracking of the cost associated with each unit sold.
Selecting the appropriate inventory costing method is crucial as it directly influences the valuation of inventory and, consequently, the calculation of COGS.
Why is cost of goods sold important?
COGS is key for companies because of its role in determining gross profit. Gross profit, calculated by subtracting COGS from total revenue, is a crucial measure of a company’s profitability and operational efficiency. So, by understanding and monitoring COGS, analysts, investors, and managers can gain insights into a company’s cost structure and its impact on overall financial performance.
What can you learn from cost of goods sold?
COGS offers valuable insights into your business’s financial performance and strategic direction. On the one hand, it’s a major contributor to your business’s margins. If your COGS exceeds your product pricing, your business may struggle to generate profits. Therefore, tracking COGS closely is essential to ensure that your business maintains healthy margins necessary for sustainable growth and profitability.
Beyond looking at the high-level COGS result, it’s crucial to delve into the underlying costs contributing to it. Analyzing each component of COGS, including material costs, labor expenses, and overheads, can help identify potential areas for cost savings and efficiency improvements.
Even incremental reductions in COGS can have a substantial impact on your bottom line. For businesses operating with narrow profit margins, such as restaurants and retail establishments, minimizing COGS is vital to enhancing profitability. Strategies to streamline operations, negotiate better supplier terms, or optimize production processes can lower COGS without compromising product quality or customer experience.
Also, while it’s essential to focus on reducing COGS to improve profitability, it’s equally crucial to maintain a long-term perspective. Avoid making short-sighted cost-cutting decisions that could jeopardize product quality, customer satisfaction, or employee morale. Balancing cost reduction efforts with the preservation of value and quality ensures the sustainability and reputation of your business over time.
All in all, understanding and effectively managing the cost of goods sold (COGS) is crucial for businesses to maintain profitability, optimize operational efficiency, and make informed strategic decisions. By leveraging insights from COGS analysis and adopting appropriate inventory costing methods, you can enhance your company’s financial performance and pave the way for sustained success.
Summary
- Cost of goods sold (COGS) refers to the direct expenses incurred by a company in producing the goods it sells, encompassing material costs, direct labor costs, and direct overheads.
- COGS determines gross profit, a crucial measure of a company’s profitability and operational efficiency. Monitoring COGS provides insights into a company’s cost structure and financial performance.
- COGS offers valuable insights into margins, efficiency, and profitability. Analyzing underlying costs helps identify areas for cost savings and efficiency improvements.
- COGS formula: Beginning inventory + Inventory costs – Ending inventory = COGS. The inventory costing method you use (FIFO, LIFO, weighted average, special identification) can affect COGS calculation.
Sources
Investopedia. Cost of Goods Sold (COGS) Explained With Methods to Calculate It.
Corporate Finance Institute. Cost of Goods Sold (COGS).
The Bottom Line. What Is Cost of Goods Sold and How Do You Calculate It?
NerdWallet. Cost of Goods Sold (COGS): Definition and How to Calculate It.
