Cost of Goods Sold: Definition
The cost of goods sold (COGS) is any direct cost related to the production of goods that are sold or the cost of inventory you acquire to sell to consumers. It does not include overhead expenses related to the general operation of the business, such as rent. Cost of goods sold is reported on a company's income statement.
COGS are a part of the income statement where costs directly related to either the product or goods sold by a company, or the costs of acquiring inventory to sell to consumers. If the cost of goods sold exceeds the revenue generated by the company during the reporting period, means that there has been no profit. The formula to calculate cost of goods sold is extremely crucial to the management as it helps analyse how well purchasing and payroll costs are being controlled.
Creditors and investors also use cost of goods sold to calculate the gross margin of the business and analyse what percentage of revenues is available to cover operating expenses. Both manufacturers and retailers list cost of goods sold on the income statement as an expense directly after the total revenues for the period. COGS is then subtracted from the total revenue to arrive at the gross margin.
The cost of goods sold formula is calculated by adding purchases for the period to the beginning inventory and subtracting the ending inventory for the period.
Cost of Goods Sold = Beginning Inventory + Purchases Ending Inventory
The beginning inventory for the current period is calculated as per the leftover inventory from the previous year. Any additional inventory which has been purchased or produced is added to the beginning inventory. To arrive at the Cost of Goods Sold, products that were not sold are subtracted from the sum of beginning inventory and additional purchases.
Cost of goods sold (COGS) is the cost of acquiring or manufacturing the products that a company sells during a period, so the only costs included in the measure are those that are directly tied to the production of the products, including the cost of labour, materials, and manufacturing overhead. For example, the COGS for an automaker would include the material costs for the parts that go into making the car plus the labour costs used to put the car together. The cost of sending the cars to dealerships and the cost of the labour used to sell the car would be excluded.
Let's apply it to an example. Say you are a car manufacturer and had a beginning inventory of INR 2,50,64,900 last month and purchased another INR 5,37,10,500 in inventory. Last month was a good month, and your remaining inventory at the end of the month was INR 89,50,187. Try and calculate COGS by yourself before you scroll down to see the answer.
Okay, now let's apply the formula.
COGS = 2,50,64,900 + 5,37,10,500 - 89,50,187
Therefore, COGS = INR 6,98,25,213
This information will not only help you plan out purchasing for the next year, it will also help you evaluate the costs. For instance, you can list the costs for each of your product categories and compare them with the sales. This comparison will give you the selling margin for each product, so you can analyse which products you are paying too much for and which products is enabling him to make the most money.
Calculation of COGS Using Different Methods
The value of the cost of goods sold depends on the inventory costing method adopted by a company. There are three methods that a company can use when recording the level of inventory sold during a period: First In, First Out (FIFO), Last In, First Out (LIFO), and the Average Cost Method.
The earliest goods to be purchased or manufactured are sold first. Since prices tend to go up over time, a company that uses the FIFO method will sell its least expensive products first, which translates to a lower COGS than the COGS recorded under LIFO. Hence, the net income using the FIFO method increases over time.
The latest goods added to the inventory are sold first. During periods of rising prices, goods with higher costs are sold first, leading to a higher COGS amount. Over time, the net income tends to decrease.
Average Cost Method
In this methd to calculate COGS, it is assumed that the inventory cost is based on the average cost of the goods available for sale during the period. The average cost is computed by dividing the total cost of goods available for sale by the total units available for sale. This gives a weighted-average unit cost that is applied to the units in the ending inventory.
Special Identification Method
This method uses the specific cost of each unit of the inventory or the goods, to derive at the ending inventory and COGS for each period. With the help of this method, a business owner or the accountant can identify which item was sold at what cost.
How Are Cost of Goods Sold and Cost of Sales Different?
Cost of goods sold is the amount at which the end product is sold at. However, costs in making those goods, which include raw materials, labor, utilities and all other costs required are categorised as cost of sales.
Why the Cost of Sales and COGS Matter?
Both cost of sales and COGS are imperative to understand the cost analysis of a company. These metrics show the operational costs that help in producing a good/service. When the cost of sales of a good/service is higher than COGS, it is a sign that your input cost is higher than your direct cost. This would impact the revenue generation and profitability, as you will are spending more in producing than getting revenue from selling.
How do you calculate cost of goods sold (COGS)?
To find the cost of goods sold during an accounting period, use the COGS formula:
COGS = Beginning Inventory + Purchases During the Period Ending Inventory
Your beginning inventory is whatever inventory is left over from the previous period. Then, add the cost of what you purchased during the period. Subtract whatever inventory you did not sell at the end of the period.
Are salaries included in COGS?
No. Salaries and other general and administrative expenses are not included in COGS. But, certain types of labor costs can be included in COGS, provided that they are directly associated with specific sales.