Cost of Goods Sold (COGS) is an accounting term that refers to the cost incurred by a company when goods are sold. In other words, cogs will show you how much it costs your company for every product that goes out the door.
As a startup founder, you’ll run into this term as you’re trying to figure out where your money is going and how much actual profit will be left in each sale.
Understanding COGS for your business can help you work towards building a sustainable and profitable company over the long-term.
Notice: COGS is subtracted from revenues to determine gross profit and gross margin.
We’ll speak about everting related to the cost of goods sold in this article.
Why Do I Need To Calculate COGS?
It’s important you know how much COGS are costing you because it will help determine the right pricing strategy for your business.
If COGS are too high, then maybe you need to lower prices or raise inventory so that there’s a bigger margin of profit on each sale.
COGS is recorded as a business expense on the income statements, which means it is considered a cost of doing business. Analysts, investors, and managers may use COGS to predict the company’s bottom line by knowing its cost. If COGS rises, net income will fall.
Company executives and investors understand the importance of lowering costs, which is why large companies have continuously sought techniques to reduce their COGS. While this reduction in COGs is beneficial for income tax purposes, the firm will lose money for its shareholders. Businesses therefore aim to keep their COGS as low as possible in order to increase net profits.
The COGS line on a cost calculation is simply the total of all costs associated with producing or obtaining items that a company sells during a time period, so only direct production-related expenses are included.
The cost of making a product, known as COGS, would include the material expenditures for components that go into the finished item as well as labor expenses associated with putting it together.
Sending cars to dealerships and labor costs involved in selling the automobile would be excluded.
Finally, COGS does not include automobile costs incurred after the year in which they were not sold. Whether the expenses are direct or indirect, they will not be factored into COGS. In other words, COGS includes the direct manufacturing cost of goods or services purchased by clients during the year.
When do COGS start?
When you begin a purchase from a supplier, the cogs are activated. COGS are the costs of goods sold on an ecommerce company, and they start as soon as we acquire merchandise.
Cost of Goods Sold = Beginning Inventory + Additional Inventory – Ending Inventory
By adding the period’s purchases to the beginning inventory and subtracting the period’s ending inventory, the cost of goods sold formula is computed.
The current period’s initial inventory (major input) is calculated based on the previous year’s residual inventory. Any additional inventory that has been acquired or manufactured is added to the initial inventory. Products that were not sold are removed from the total of beginning inventory and additional acquisitions to arrive at the Cost of Goods Sold.
The current assets account is one of the accounts on the balance sheet. The inventory item is contained in this account. A company’s financial health is only evaluated at the end of an accounting period using the balance sheet.
The ending inventory is the current asset’s value recorded in the balance sheet.
Since the beginning inventory is the inventory a business has on hand at the start of its accounting year, it also indicates that the previous accounting period’s ending inventory is also the company’s starting inventory at the conclusion of that period.
Cost of Goods Sold Example
A fine jewelry ecommerce site is being operated. To figure out cost of goods sold, a firm must first determine the value of its inventory at the start of the year, which is what it was worth at the conclusion of the previous year.
Then, the manufacturer’s yearly cost to produce its jewelry is added to the initial value. Raw material expenses, labor costs, and shipping fees to clients might all be included in this category.
Finally, the beginning value and expenses are subtracted from the value of the company’s inventory. This will give the ecommerce site a precise cost of goods sold for its firm.
How to leverage accounting methods to reduce COGS
The cost of goods sold is determined using one of three inventory costing approaches, each with its own set of advantages and disadvantages. The company may utilize one method or a combination of methods to account for quantity sold during any given period.
Note: we have covered these methods (and more) in comprehensive guide: Valuing Inventory – 6 Inventory Costing Methods
FIFO (First in First out)
The FIFO method of valuation is one of the most popular and easy to use methods.
When we apply this concept to inventory accounting, we assume that the first product bought was also the first product sold and vice versa.
However, the cost of the first product bought may not be equal to the cost of the first product sold.
LIFO (Last in First Out)
The LIFO is the inverse of the FIFO.
Under this concept, you value your inventory by assuming that the last item bought was also the first one sold.
However, it is not necessary to do so at all times.
This inventory costing method may show a lower cost of your inventory, but it is not always true.
Average Costing Method
Average costing method shows the average cost of all items in stock.
When your business decides to sell an item, the average cost of all items in stock will be used to record the sale.
This inventory costing method is beneficial to businesses for a variety of reasons. The weighted average of all the inventory that the business acquired throughout a period of time is used to assign value to COGS.
As long as the length stays consistent, it may be a month, quarter, or yearly period.
Specific Identification Costing Method
This method assigns an individual cost to specific goods. When a product is sold, the cost of that product (specifically identified) will be removed from the balance sheet.
Specific identification becomes beneficial when you are trying to price your goods correctly. It’s the only cost allocation method that uses costs specifically attributed to an item or product.
It’s beneficial and practical, when a firm is able to identify, label, and track each item or unit in its inventory.
Market Valuation Method.
Market valuation method is the most widely used inventory costing method by small and medium-sized business owners.
The market valuation method is a way to estimate the value of an asset by comparing it to the values of similar assets.
In some cases, such as that of residential real estate or publicly traded stocks, there is usually a lot of data accessible, making market research straightforward. It can become quite difficult to find comparable transactions in markets like shares in private businesses or alternative investments such as fine art or wine.
The retail inventory Costing method
The retail method measures the cost of inventory compared to the price of goods to get an ending inventory balance for a business. In other words, it determines how much expense should be recognized in this time versus the next.
The retail method is a great way to sell products and make money. If you have consistent markup, it’s simple for your business because everything has the same price tag on all of its items as well!
This approach is based on the relationship between a product’s cost and its retail price.
Exception From COGS Deduction
Some businesses may not include any expenses related to the sale of goods. COGS is not addressed in great detail in Generally Accepted Accounting Standards (GAAP), but it is defined as the cost of inventory sold during a specific period. Service providers don’t have any goods to sell, and only service firms lack inventories. No deduction can be taken.
Accounting firms, law offices, real estate appraisers, business consultants, professional dancers, and other professions are examples of service enterprises that provide objective services.
Despite the fact that all of these businesses have commercial expenses and regularly spend money to deliver their services, they do not list COGS. Instead, they include what is known as “cost of services”
COGS vs Operating Expenses
Operating costs and cost of goods sold (COGS) are expenses that businesses incur in running their operations. The expenses, on the other hand, are divided across the income statement.
Unlike COGS, operating expenditures are funds spent for activities that aren’t directly related to the production of items or services.
Typically, selling, general, and administrative costs are included as a distinct line item in operating expenses.
These costs are spending incurred for things other than the manufacture of goods. like rent, utilities, legal costs, sales & marketing, Insurance costs.
Limitations of COGS
Accountants or management may easily modify COGS to deceive the books. It can be changed by:
- Allocating to higher manufacturing overhead expenses than those incurred in processing
- Overestimating discounts
- Exaggerating the profit margin of suppliers
- Changes in inventory levels at the end of an accounting period
- Inflating the value of your inventory on hand
COGS will be under-reported when inventory is fraudulently increased, resulting in a lower than genuine gross profit margin and hence an inflated net income.
By examining a company’s profit & loss statements, investors may identify fraudulent inventory accounting by noting whether inventory accumulation exists, such as when sales surpass total assets or vice versa.
Taxes and COGS Relationship
The Cost of Goods Sold is a tax reporting obligation. To deduct the cost, businesses must calculate COGS according to the IRS. This lowers their total tax burden.
Small firms with an average gross revenue (before costs or expenses) of less than $25 million in the three preceding tax years use COGS. To establish these expenditures, they must keep comprehensive and accurate accounting records.
To calculate COGS, a firm must first establish the value of its inventory at the start and end of each tax year. To determine cost of goods sold,
An increase in the cost of goods sold implies a business pays less tax while at the same time generating less income. Something has to be adjusted. In order to improve earnings, costs of goods should be reduced.
How Do You Calculate Cost of Goods Sold (COGS)?
COGS is the total of all direct costs incurred to generate a company’s revenues. Importantly, COGS is limited to the expenses that are directly utilized in producing revenue, such as inventory or labor expenditures that can be linked to specific sales.
Note: Fixed expenses such as managerial salaries, rent, and utilities are not included in COGS.
Are Salaries Included in COGS?
Salaries and other general and administrative costs are not included in COGS. However, certain labor expenditures might be included in COGS if they can be readily linked to specific sales. For example, a firm that utilizes contractors to produce revenues may pay those contractors a fee based on the price charged to the client.
Is Rent Included in COGS?
No, rent is not included in COGS. Rent and other operating expenses are considered part of normal business expenses. These costs are usually listed as a distinct line item on an income statement, separate from COGS.
What cogs will affect?
COGS can be used to calculate the cost of goods sold in an e-commerce business. It is a key metric in determining pricing and profitability. COGS are calculated when you purchase inventory from a supplier, so it starts as soon as you buy inventory.
How Does Inventory Affect COGS?
COGS should include the full cost of all items sold during the accounting period. In reality, businesses frequently don’t know which units of inventory were sold.
They instead utilize accounting techniques such as the First In, First Out (FIFO) and Last In, First Out (LIFO) rules to estimate what inventory was sold during the period. If COGS includes a large amount of inventory, this will put downward pressure on gross profit. As a result, businesses may choose accounting methods that produce
Purpose of Cost of Goods Sold
The fundamental aim of calculating COGS is to determine the “real cost” of items sold during the period. It doesn’t take into account purchases that aren’t being sold or merely kept in stock. It aids management and investors in monitoring business performance.