Cost of Goods Sold or COGS refers to the cost of producing goods and services. Also known as the cost of services or cost of sales, it includes direct labor, as well as the material cost in producing the goods. While calculating COGS, the cost of unsold goods or services is not taking into account. Further, the item does not include overhead costs and other expenses such as fees, marketing expenses, and utilities.
For instance, for a company dealing in manufacturing furniture, items such as wood, screws, hinges, labor, glass, and paint would make up COGS. On the other hand, costs such as shipping and marketing the furniture must not come under COGS.
Purpose of Calculating COGS
Calculating the cost of goods sold is important to the company as it is a measure of the real cost of producing a product. Specifically, COGS helps the company will in determining the following items:
COGS gives the company a good idea of the cost of the product. So, using this, the company can easily make a decision regarding the selling price of the product. A company can use the COGS and the profit margin together to set the price of the product. For example, if the cost of goods sold is $10, then the selling price would have to be higher than this.
COGS also help creditors and investors to arrive at the gross margin of the business and understand the portion of revenue that a company can use to cover the operating expenses. COGS comes in the income statement after recording the total revenue for the year. To arrive at the gross margin, we subtract the cost of goods sold from the total revenue.
Together, both pricing and gross profit help the management to assess the efficiency of the company in controlling the payroll and the purchase cost.
Cost of Goods Sold Formula
One can calculate the Cost of Goods Sold by adding the purchases to the opening inventory and subtracting the closing inventory for the period.
COGS = Opening Inventory + Purchases – Ending Inventory
Since the idea is to calculate the cost of the good that a company sells during a period to the end-user, subtracting closing inventory makes sense. Starting with the beginning inventory and then adding the new inventory tells the cost of all inventory. At no point in time the inventory that remains unsold during the period should be included in the calculation of COGS.
Let us understand the calculation with the help of a simple example. Suppose Company A has an opening inventory of $9,000, while the purchase for the current year is $4,000 and the closing inventory is $3,000. Here COGS will be $9,000+$4,000-$3,000 = $10,000.
Now, one can use this figure to arrive at the gross profit. If the net revenue is $18,000, then the gross profit is $8,000.
Different Accounting Methods
For calculating the COGS, the inventory sold is taken into account. Usually, there is no clarity over the order in which the goods should be sold. This can give way to confusion while estimating the true value.
So, to avoid confusion, a company can either use First in First Out (FIFO) or the Last in First Out (LIFO), Weighted Average, or Specific identification. All these costing methods have different implications on the calculation.
As the name suggests, under FIFO, one assumes that the products first in are also the first to be sold to the end customer. Therefore, the current inventory would include more recent prices. This is the best way in case the price of the inventory is highly fluctuating. FIFO is an acceptable method of calculating inventory under Generally Accepted Accounting Principles (GAAP) and International Finance Reporting Standards.
LIFO stands for last in, first out and is the exact opposite of FIFO. Under this, the stock that comes in the last is sold first. If the price of the inventory does not fluctuate often, LIFO can be useful for the calculation of the prices of the inventory.
For instance, a company buys three units at $5 each, then the next three at $6 each, and the total sale in 3 units. Under FIFO, the company sells the first three units costing $5. Hence, closing inventory will be (3*$6) $18. Similarly, the last three will sell under LIFO, and thus, the inventory will be (3*$5) $15.
Under this, one has to divide the total cost of goods available for sale by the total units available for sale. This gives the cost of each product, and multiplying it by the actual number of units sold gives the cost of goods sold. Taking the above example, the total cost will be (3*$5+3*$6) $33, and thus, the weighted average will be ($33/6) $5.5. So, the closing inventory will be (3*$5.5) $16.5.
Organizations with specifically identifiable inventory use this. Under this, costs are specially assigned to the specific unit sold. Such type of accounting is possible for car makers, real estate developers, and more.
The type of inventory system that the company uses to determine a purchase also affects the cost of goods sold. Companies either use the perpetual or periodic method.
This process takes into account the merchandise in real-time. A company adds or deletes the items in the books as soon as it buys or sells them. If a company wants to monitor the real income throughout the year, the perpetual method is the best way. However, on the cost front, the perpetual system of maintaining inventory might be a little expensive.
Under the periodic method, one calculates the cost of merchandise at different time intervals throughout the year. Mostly, the companies update the sheet quarterly and then annually. As much cost-effective as this method is, it never captures the real picture like the perpetual way does.
Service companies do not have goods to sell, and therefore, you might not find the COGS column at all. Further, the service companies might not even have the inventory. Some example of service firms is law firms, accounting companies, business consultants, and so on. Such firms show the cost of services and not the cost of goods sold.
Since many factors go into the calculation of the COGS, it becomes easier to manipulate and report wrong numbers. A company can falsely report the number by overstating the discounts and returns to the suppliers, along with overestimating inventory at hand and so on.
Nevertheless, it still is a very useful tool if a company uses it properly. COGS hold value for both management and external users to analyze how well a company is clearing its inventory and how its profit margins are.
Read What is Expense? to learn more about various other types of expenses.