Cost of Goods Sold (COGS) Explained With Methods to Calculate It (2023)

What Is Cost of Goods Sold (COGS)?

Cost of goods sold (COGS) refers to the direct costs of producing the goods sold by a company. This amount includes the cost of the materials and labor directly used to create the good. It excludes indirect expenses, such as distribution costs and sales force costs.

Cost of goods sold is also referred to as "cost of sales."

Key Takeaways

  • Cost of goods sold (COGS) includes all of the costs and expenses directly related to the production of goods.
  • COGS excludes indirect costs such as overhead and sales & marketing.
  • COGS is deducted from revenues (sales) in order to calculate gross profit and gross margin. Higher COGS results in lower margins.
  • The value of COGS will change depending on the accounting standards used in the calculation.
  • COGS differs from operating expenses(OPEX) in that OPEX includes expenditures that arenot directly tied tothe production of goods or services.

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(Video) Cost Of Goods Sold (COGS) explained

Examining Costs Of Goods Sold (COGS)

Understanding Cost of Goods Sold (COGS)

COGS is an important metric on the financial statements as it is subtracted from a company’s revenues to determine its gross profit. The gross profit is a profitability measure that evaluates how efficient a company is in managing its labor and supplies in the production process.

Because COGS is a cost of doing business, it is recorded as a business expense on the income statements. Knowing the cost of goods sold helps analysts, investors, and managers estimate the company’s bottom line. If COGS increases, net income will decrease. While this movement is beneficial for income tax purposes, the business will have less profit for its shareholders. Businesses thus try to keep their COGS low so that net profits will be higher.

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 labor, materials, and manufacturing overhead.

For example, COGS for an automaker would include the material costs for the parts that go into making the car plus the labor costs used to put the car together. The cost of sending the cars to dealerships and the cost of the labor used to sell the car would be excluded.

Furthermore, costs incurred on the cars that were not sold during the year will not be included when calculating COGS, whether the costs are direct or indirect. In other words, COGS includes the direct cost of producing goods or services that were purchased by customers during the year. As a rule of thumb, if you want to know if an expense falls under COGS, ask: "Would this expense have been an expense even if no sales were generated?"

COGS only applies to those costs directly related to producing goods intended for sale.

(Video) What is Cost of Goods Sold (COGS)? How to calculate it using the formula with example? | Orderhive

Formula and Calculation of Cost of Goods Sold (COGS)

COGS=BeginningInventory+PEndingInventorywhereP=Purchasesduringtheperiod\begin{aligned} &\text{COGS}=\text{Beginning Inventory}+\text{P}-\text{Ending Inventory}\\ &\textbf{where}\\ &\text{P}=\text{Purchases during the period}\\ \end{aligned}COGS=BeginningInventory+PEndingInventorywhereP=Purchasesduringtheperiod

Inventory that is sold appears in the income statement under the COGS account. The beginning inventory for the year is the inventory left over from the previous year—that is, the merchandise that was not sold in the previous year.

Any additional productions or purchases made by a manufacturing or retail company are added to the beginning inventory. At the end of the year, the products that were not sold are subtracted from the sum of beginning inventory and additional purchases. The final number derived from the calculation is the cost of goods sold for the year.

The balance sheet has an account called the current assets account. Under this account is an item called inventory. The balance sheet only captures a company’s financial health at the end of an accounting period. This means that the inventory value recorded under current assets is the ending inventory.

Accounting Methods and COGS

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 special identification method is used for high-ticket or unique items.

FIFO

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.

LIFO

LIFO is where 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.

(Video) How To Calculate Cost Of Goods (COG)

Average Cost Method

The average price of all the goods in stock, regardless of purchase date, is used to value the goods sold. Taking the average product cost over a time period has a smoothing effect that prevents COGS from being highly impacted by the extreme costs of one or more acquisitions or purchases.

Special Identification Method

The special identification method uses the specific cost of each unit of merchandise (also called inventory or goods) to calculate the ending inventory and COGS for each period. In this method, a business knows precisely which item was sold and the exact cost. Further, this method is typically used in industries that sell unique items like cars, real estate, and rare and precious jewels.

Exclusions From COGS Deduction

Many service companies do not have any cost of goods sold at all. COGS is not addressed in any detail ingenerally accepted accounting principles(GAAP), but COGS is defined as only the cost of inventory items sold during a given period. Not only do service companies have no goods to sell, but purely service companies also do not have inventories. If COGS is not listed on the income statement, no deduction can be applied for those costs.

Examples of pure service companies include accounting firms, law offices, real estateappraisers, business consultants, professional dancers, etc. Even though all of these industries havebusiness expensesand normally spend money to provide their services, they do not list COGS. Instead, they have what is called "cost of services," which does not count towards a COGS deduction.

Cost of Revenue vs. COGS

Costs of revenueexist for ongoing contract services that can include raw materials, direct labor, shipping costs, and commissions paid to sales employees. These items cannot be claimed as COGS without a physically produced product to sell, however. The IRS website even lists some examples of "personal service businesses" that do not calculate COGS on their income statements. These include doctors, lawyers, carpenters, and painters.

Many service-based companies have some products to sell. For example, airlines and hotels are primarily providers of services such as transport and lodging, respectively, yet they also sell gifts, food, beverages, and other items. These items are definitely considered goods, and these companies certainly have inventories of such goods. Both of these industries can list COGS on their income statements and claim them for tax purposes.

Operating Expenses vs. COGS

Both operating expensesand cost of goods sold(COGS) are expenditures that companiesincur with running their business; however, the expenses are segregatedon the income statement. Unlike COGS, operating expenses(OPEX) are expenditures that arenot directly tied tothe production of goods or services.

Typically,SG&A (selling, general, and administrative expenses) areincluded under operating expenses as a separate line item. SG&A expenses are expendituresthat are not directly tied to aproductsuch asoverhead costs. Examples of operating expensesinclude the following:

(Video) Cost of Goods Sold (COGS)

  • Rent
  • Utilities
  • Office supplies
  • Legal costs
  • Sales andmarketing
  • Payroll
  • Insurance costs

Limitations of COGS

COGS can easily be manipulated by accountants or managers looking to cook the books. It can be altered by:

  • Allocating to inventory higher manufacturing overhead costs than those incurred
  • Overstating discounts
  • Overstating returns to suppliers
  • Altering the amount of inventory in stock at the end of an accounting period
  • Overvaluing inventory on hand
  • Failing to write off obsolete inventory

When inventory is artificially inflated, COGS will be under-reported which, in turn, will lead to higher than the actual gross profit margin, and hence, an inflated net income.

Investors looking through a company’s financial statements can spot unscrupulous inventory accounting by checking for inventory buildup, such as inventory rising faster than revenue or total assets reported.

How Do You Calculate Cost of Goods Sold (COGS)?

Cost of goods sold (COGS) is calculated by adding up the various direct costs required to generate a company’s revenues. Importantly, COGS is based only on the costs that are directly utilized in producing that revenue, such as the company’s inventory or labor costs that can be attributed to specific sales. By contrast, fixed costs such as managerial salaries, rent, and utilities are not included in COGS. Inventory is a particularly important component of COGS, and accounting rules permit several different approaches for how to include it in the calculation.

Are Salaries Included in COGS?

COGS does not include salaries and other general and administrative expenses; however, certain types of labor costs can be included in COGS, provided that they can be directly associated with specific sales. For example, a company that uses contractors to generate revenues might pay those contractors a commission based on the price charged to the customer. In that scenario, the commission earned by the contractors might be included in the company’s COGS, since that labor cost is directly connected to the revenues being generated.

How Does Inventory Affect COGS?

In theory, COGS should include the cost of all inventory that was sold during the accounting period. In practice, however, companies often don’t know exactly which units of inventory were sold. Instead, they rely on accounting methods such as the first in, first out (FIFO) and last in, first out (LIFO) rules to estimate what value of inventory was actually sold in the period. If the inventory value included in COGS is relatively high, then this will place downward pressure on the company’s gross profit. For this reason, companies sometimes choose accounting methods that will produce a lower COGS figure, in an attempt to boost their reported profitability.

(Video) Average Cost Method Explained | How To Find COGS (Cost of Goods Sold)

The Bottom Line

Cost of goods sold is the direct cost of producing a good, which includes the cost of the materials and labor used to create the good. COGS directly impacts a company's profits as COGS is subtracted from revenue. Companies must manage their COGS to ensure higher profits. If a company can reduce its COGS through better deals with suppliers or through more efficiency in the production process, it can be more profitable.

FAQs

How do you calculate COGS from cost of goods sold? ›

COGS = Beginning Finished Goods Inventory + Cost of Goods Manufactured – Ending Finished Goods Inventory. Delving into the calculation in a bit more detail, we can see that the COGS equation includes all three basic inventory types – the raw materials, WIP, and finished goods inventories.

How do you calculate cost of goods sold is calculated to be? ›

COGS = Beginning inventory + purchases + Freight In – Ending inventory – Purchase Discounts – Purchase Returns and Allowances.

How many ways can you calculate cost of goods sold? ›

Calculation of COGS Using Different Methods

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.

How do you explain cost of goods sold? ›

The cost of goods sold (GOGS) is the sum of all direct cost associated with making a product. It appears on an income statement and typically includes money spent on raw materials and labour. It does not include coss associated with marketing, sales or distribution.

What is cost of goods sold with example? ›

The cost of goods made or bought is adjusted according to change in inventory. For example, if 500 units are made or bought but inventory rises by 50 units, then the cost of 450 units is cost of goods sold. If inventory decreases by 50 units, the cost of 550 units is cost of goods sold.

How is the cost of goods sold calculated Class 11? ›

Cost of Goods Sold = Opening Stock + Net Purchase - Closing Stock + Direct Labour / Expenses.

What is the best method to use in computing for COGS? ›

Or, to put it another way, the formula for calculating COGS is: Starting inventory + purchases - ending inventory = cost of goods sold.

How do you calculate selling cost of sales? ›

To calculate the cost of sales, add your beginning inventory to the purchases made during the period and subtract that from your ending inventory. To calculate the total values of sales, multiply the average price per product or service sold by the number of products or services sold.

Which method gives the highest COGS? ›

During periods of inflation, the use of LIFO will result in the highest estimate of cost of goods sold among the three approaches, and the lowest net income.

What are the types of cost of goods sold? ›

Examples of costs generally considered COGS include:
  • Raw materials.
  • Items purchased for resale.
  • Freight-in costs.
  • Purchase returns and allowances.
  • Trade or cash discounts.
  • Factory labor.
  • Parts used in production.
  • Storage costs.
18 Jan 2021

Why is cost of goods sold important? ›

Understanding Cost of Goods Sold (COGS)

COGS is an important metric on the financial statements as it is subtracted from a company's revenues to determine its gross profit. The gross profit is a profitability measure that evaluates how efficient a company is in managing its labor and supplies in the production process.

What is another word for cost of goods sold? ›

COGS is sometimes referred to as cost of merchandise sold or cost of sales. Some companies that sell a mix of products and services prefer a broader term, cost of revenue, of which COGS is one component.

How do you calculate cost of goods sold PDF? ›

Expressed as a formula, it looks like this: Beginning Inventory + Purchases – End Inventory = COGS Example 1: Suppose the opening inventory is Rs. 30,000 and purchases during the period are Rs. 50,000.

How do you calculate cost of goods sold for a Class 12? ›

Cost of Good Sold Formula = Beginning Inventory + Purchases – Ending Inventory.

How do you find the selling price of a Class 7? ›

Important Selling Price Formula
  1. Selling price = Cost price + Profit.
  2. Selling price = Marked/List price – Discount.
  3. Selling price = \frac{100 + Profit}{100} × Cost price.
  4. Selling price = \frac{100- Loss}{100} × Cost price.

What is the easiest way to calculate cost of goods sold? ›

At a basic level, the cost of goods sold formula is: Starting inventory + purchases − ending inventory = cost of goods sold.

What methods can be used to calculate average cost? ›

You can determine the ATC with a simple equation:
  • Average Total Cost = Total Cost of Production / Quantity of Units Produced.
  • Average Total Cost = Average Fixed Cost + Average Variable Cost.
  • Average Total Cost = Total Cost of Production / Quantity of Units Produced.

How is Cogas calculated? ›

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. The cost of goods sold equation might seem a little strange at first, but it makes sense.

What is cost of goods sold in accounting? ›

Cost of goods sold is the total amount your business paid as a cost directly related to the sale of products. Depending on your business, that may include products purchased for resale, raw materials, packaging, and direct labor related to producing or selling the good.

Is cost of sales and COGS the same? ›

Cost of sales and cost of goods sold (COGS) both measure what a business spends to produce a good or service. The terms are interchangeable and include the cost of labor, raw materials and overhead costs associated with running a production facility.

What is the formula for sales? ›

Based on this information, let us calculate the gross sales and the net sales. The net sales will be computed with the formula net sales = gross sales – returns – allowances – discounts. The net sales would be $90,000 - $500 - $100 - $1000 = $88,400.

What are the 3 main methods of taking inventory? ›

The three inventory costing methods include the first in-first out (FIFO), last in-first out (LIFO), and weighted average cost (WAC) methods.

What are the 4 inventory methods? ›

The four main inventory valuation methods are FIFO or First-In, First-Out; LIFO or Last-In, First-Out; Specific Identification; and Weighted Average Cost. We'll dive deeper into these – but first, let's go over some basics.

What are the 3 methods to value inventory? ›

What are the different inventory valuation methods? There are three methods for inventory valuation: FIFO (First In, First Out), LIFO (Last In, First Out), and WAC (Weighted Average Cost). In FIFO, you assume that the first items purchased are the first to leave the warehouse.

What is COGS and how is it calculated? ›

Cost of goods sold (COGS) is calculated by taking the value of inventory at the beginning of the period being studied, adding the cost of any new inventory purchased over the covered period, and subtracting the value of inventory held at the end of the period. COGS = Beginning Inventory + Purchases – Ending Inventory.

What are the 4 types of cost? ›

Costs are broadly classified into four types: fixed cost, variable cost, direct cost, and indirect cost.

What are the main 3 types of cost? ›

These expenses include:
  • Variable costs: This type of expense is one that varies depending on the company's needs and usage during the production process. ...
  • Fixed costs: Fixed costs are expenses that don't change despite the level of production. ...
  • Direct costs: These costs are directly related to manufacturing a product.

Is cost of products sold the same as COGS? ›

Cost of sales and cost of goods sold (COGS) both measure what a business spends to produce a good or service. The terms are interchangeable and include the cost of labor, raw materials and overhead costs associated with running a production facility.

How do you find COGS without ending inventory? ›

Here are the three steps: Calculate the cost of goods available for sale: Add the cost of beginning inventory to the cost of purchases during the same period. Calculate the cost of goods sold: Multiply the gross profit percentage by sales in the period.

How do you calculate COGS from a balance sheet? ›

The cost of goods sold formula, also referred to as the COGS formula is: Beginning Inventory + New Purchases - Ending Inventory = Cost of Goods Sold. The beginning inventory is the inventory balance on the balance sheet from the previous accounting period.

What type is cost of goods sold? ›

Cost of goods sold is considered an expense in accounting and it can be found on a financial report called an income statement.

What is COGS also known as? ›

Cost of goods sold may also be referred to as “cost of sales.” Public companies are required by law to share this information in their annual reports, so you can always look at cost of goods sold, or cost of sales, for any company listed on a major U.S. stock exchange.

What is cost of goods sold used for? ›

Cost of goods sold (COGS) is an important line item on an income statement. It reflects the cost of producing a good or service for sale to a customer. The IRS allows for COGS to be included in tax returns and can reduce your business's taxable income.

What is FIFO method? ›

First In, First Out, commonly known as FIFO, is an asset-management and valuation method in which assets produced or acquired first are sold, used, or disposed of first. For tax purposes, FIFO assumes that assets with the oldest costs are included in the income statement's cost of goods sold (COGS).

What is not included in COGS? ›

On the flip side, items that are excluded from COGS include selling, general and administrative expenses such as distribution costs to customers, office rents, advertising, accounting and legal fees, and management salaries.

How do you calculate COGS using the FIFO method? ›

To calculate COGS (Cost of Goods Sold) using the FIFO method, determine the cost of your oldest inventory. Multiply that cost by the amount of inventory sold. Please note: If the price paid for the inventory fluctuates during the specific time period you are calculating COGS for, that must be taken into account too.

How is Cogp calculated? ›

The cost of goods purchased is the net cost of merchandise acquired. The calculation is to add freight in to the initial purchase cost and then subtract purchase allowances, purchase discounts, and purchase returns.

How do you calculate COGS and inventory purchases? ›

The formula is (COGS + ending inventory) – purchases.

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