What Is Cost of Goods Sold and How to Calculate It

If your company sells products, there’s one vital metric that you should be able to calculate and track – COGS, or Cost of Goods Sold.

COGS is a powerful indicator that can make or break your financial health. It’s among the top signals for revenue, profit, and sustainability in the world of business.

In the following sections, we explore Cost of Goods Sold in detail, uncovering valuable insights that you’ll need as a business owner and leader. 

What Is Cost of Goods Sold (COGS)?

Cost of Goods Sold represents the direct costs involved in producing goods or services that a business sells during a specific accounting period. In other words, this business and sales metric shows the accumulated cost of creating or acquiring the goods or services you sell to your clients. 

By taking into account all costs directly linked to your inventory, COGS helps determine a company’s gross profit. It’s also key for evaluating pricing strategies, operational efficiency, and ultimately, financial health. 

Cost of Goods Sold can be found on a company’s income statement and is listed as a direct business expense. 

What Costs Are Included in COGS?

So far, we mentioned that COGS factors in all costs related to producing the products or services that a business sells. But what are the direct costs incurred exactly?

Most are variable costs, like materials and labour, while others are fixed costs, like storage costs.

Direct Costs

Generally, COGS demonstrates the direct costs attributed to the creation of products sold by a business. 

These direct costs consist of:

• Raw materials – supplies used in manufacturing the product;
• Direct labour costs – wages paid to workers and employees who produce goods;
• Manufacturing costs – costs for equipment use, production tools, and utilities;
• Storage costs – expenses for storing goods or equipment used for production;
• Other costs – costs like trade and cash discounts, freight-in, and total costs. 

All of these costs must be taken into account when calculating Cost of Goods Sold.

Inventory Costs

In addition, there are also inventory costs that go into the equation. 

These costs represent the expenses of managing inventory throughout the accounting period and include:

• Beginning inventory –  how much inventory there is at the start of the period;
• Ending inventory – how much unsold inventory there is at the end of the period;
• Inventory purchases – goods purchased or produced during the period.

Later, when we look at the Cost of Goods Sold calculation process, we’ll explain how these are used.

Excluded Costs

Finally, there are certain costs that are excluded from the COGS calculation.

For example, Cost of Goods Sold excludes indirect expenses. These include operating expenses, like office supplies, marketing, distribution costs, and rent. It also excludes administrative costs or general overhead costs that are not strictly related to the production of goods. 

Although not included in the actual calculations, some excluded costs may have a significant impact on the bigger picture. For instance, payment terminals are considered an operating expense rather than a direct cost. They are, therefore, excluded from COGS calculations. At the same time, they influence Cost of Goods Sold directly as they track sales transactions, which are necessary when calculating how much inventory has been sold. 

How to Calculate Cost of Goods Sold

Now that we’ve covered the basics of this metric, it’s time to dive deeper into the formula for Cost of Goods Sold.

To calculate COGS, you’ll need to have all of the required pieces of the following equation:

COGS = Beginning Inventory + Purchases During Period − Ending Inventory

In this formula, the beginning inventory is the value of inventory carried over from the previous period. The purchases during period represent any extra inventory that has been purchased or produced during the accounting period. Lastly, ending inventory is the closing stock or the value of inventory that remains unsold at the end of the period. 

Examples of Calculating COGS

Let’s look at a few examples of Cost of Goods Sold. 

Imagine a shoe shop that sells trainers. At the beginning of September, it had £15,000 worth of trainers in stock. Anticipating high demand for spring, the shop purchases another £25,000 worth of trainers during the month. By the end of September, the shop has £5,000 worth of trainers left in inventory.

The variables are:

• Beginning Inventory – £15,000
• Purchased Inventory – £25,000
• Ending Inventory – £5,000

Let’s work out the numbers by using the formula:

COGS = Beginning Inventory + Purchased Inventory − Ending Inventory

COGS= £15,000 + £25,000 − £5, 000

COGS = £35,000

This means the Cost of Goods Sold, or the total cost of goods sold during September, is £35,000, representing the direct cost of the trainers sold during that month.

Methods for Calculating COGS

When discussing COGS, it’s essential to note that there are several ways this metric can be calculated.

No matter the inventory method you select, make sure you choose a technique that fits in with your business and be consistent. 

First In, First Out (FIFO)

The First In, First Out or FIFO method works on the principle that the oldest inventory is sold first, making it an order-of-production method. In other words, the oldest goods are sold before the newer goods.

When there’s an increase in labour or material costs, using the FIFO method means that the ending inventory is valued at the newer, higher prices, making COGS lower than in other calculation methods. 

The First In, First Out approach is, therefore, most suitable for businesses where inventory costs are rising, as it shows a lower COGS and higher profits.

Last In, First Out (LIFO)

On the other hand, the Last In, First Out or LIFO method is the complete opposite. It’s a reverse-production-order approach where the assumption is that the newest inventory is sold first. 

Here, the main theory is that the newly produced goods are already sold. In this case, when raw materials and labour costs increase, LIFO gives a lower per-unit inventory valuation for the remaining goods as they were produced earlier in the accounting period, making COGS higher and reducing taxable income. 

Weighted Average Cost Method

The Weighted Average Cost Method can be described as a combination of the FIFO and LIFO approaches. 

It averages the cost of all inventory units available during the period. Unlike FIFO and LIFO, the Weighted Average Cost Method does not take into account the purchase date of the goods. 

This approach is mostly suitable for companies with indistinguishable or high-turnover inventory.

Specific Identification Method

Last but not least, some organisations can calculate COGS using the Specific Identification Method.

As the name suggests, this method can only be used by those with specifically identifiable inventory. It tracks the actual cost of each specific item sold.

Naturally, the Specific Identification Method suits businesses selling unique or high-value items.

Why Calculating COGS Is Important for Businesses

Earlier, we mentioned that COGS is one of the most important metrics for business owners and decision-makers. 

Here’s why.

Determining Gross Profit

One of the most important reasons for calculating COGS is that it enables companies to calculate Gross Profit – a metric that shows how efficiently a business is producing and selling goods.

You can identify Gross Profit by subtracting Cost of Goods Sold from sales revenue. A higher COGS means a lower gross profit. 

The metric is, therefore, also vital for establishing the Gross Margin. You can get this metric by dividing Gross Profit by revenue. 

Financial Analysis and Decision-Making

In addition to calculating Gross Profit, Cost of Goods Sold is also a critical metric for analysing the financial position of a company and making informed decisions.

COGS can help business leaders accurately evaluate profitability and control production costs, ultimately enhancing cost control. It can also reveal key insights that can be used to improve pricing strategies and ensure goods are priced above their production costs. 

Inventory Management

Another powerful capability of COGS is making improvements in inventory management. 

COGS tells you exactly how much it costs to sell the items you moved out of inventory. Without this piece of information, companies won’t have the ability to measure how efficiently they’re managing purchases, production, and sales. 

When linking inventory costs to sales, businesses can identify the products that are profitable and those that might be draining resources. Ultimately, this creates opportunities for better stocking decisions. 

Tax Reporting

Last but not least, Cost of Goods Sold is mandatory for income tax purposes. Both Generally Accepted Accounting Principles (GAAP) and Financial Reporting Standards (FRS) require COGS for income tax filing. 

COGS is a tax-deductible expense, reducing taxable income and tax liability. The higher the Cost of Goods Sold of a business, the lower its taxes. 

Cost of Goods Sold vs. Cost of Sales: Key Differences

Cost of Goods Sold is often confused with Cost of Sales – another important metric in business.

While these two terms are commonly used interchangeably, they represent two entirely different things. While Cost of Goods Sold calculates the costs of producing a product, Cost of Sales refers to the cost of a product which has already been sold or the costs of inventory sold.

Naturally, this means that COGS is generally more suitable for manufacturers, while Cost of Sales is better suited to service-only businesses, where the direct costs of a sale are much harder to analyse. 

Common Challenges in Calculating COGS

While calculating Cost of Goods Sold is a simple task once you’ve collected accurate data and are fully aware of the process, there are some challenges that must be considered.

Here are the most popular mistakes companies make when approaching COGS calculations:

• Inventory valuation errors – Incorrect recording of beginning or ending inventory values can distort COGS, causing discrepancies in a range of other metrics and calculations afterwards.
  
• Choosing the right accounting method – Selecting the right inventory valuation method between FIFO, LIFO, and Weighted Average can seriously impact profitability and tax outcomes.
  
• Indirect costs confusion – Mistaking indirect expenses, like rent, administrative costs, or other costs as part of COGS is also a popular mistake that companies should be cautious of.
  
• Managing physical inventory – Businesses must ensure accurate physical counts and valuation of inventory.

Being aware of these challenges before calculating COGS can help you eliminate any risks and achieve more accurate and reliable results. 

How Businesses Can Optimise COGS

Calculating Cost of Goods Sold is only the beginning. An accurate calculation can help you detect weak areas in your processes, enabling you to make improvements in the future. 

But how can you optimise COGS in order to achieve this and more?

We recommend putting in place the following:

• Improve inventory management – Put in place inventory tracking systems to maintain accurate stock records and, if possible, use software solutions to streamline inventory and COGS calculations. This will help minimise risks of human error.
  
• Negotiate supplier pricing – Try to lower raw material costs by negotiating better terms with suppliers and partners.
  
• Streamline production efficiency – Explore every avenue for reducing direct labour costs and overhead. One of the proven methods to achieve this is by making improvements in production processes.
  
• Monitor cash flow – Regularly analyse COGS to identify cost-saving opportunities and improve operational efficiency.

By optimising COGS, you can witness significant improvements in profitability and operational efficiency. You can boost your profit margins, strengthen your pricing strategy, improve cash flow, and enjoy long-term scalability and confidence in the face of investors and stakeholders.

Frequently Asked Questions

How does inventory affect COGS?

Inventory plays a crucial role in shaping a company’s COGS. When ending inventory is higher, fewer costs are pushed into COGS, making it appear lower. On the other hand, when ending inventory is lower, more costs flow into COGS, driving it up.

Can Cost of Goods Sold be used to improve profitability?

Yes, COGS can help improve profitability as it shows whether production is efficient or not. You can use this metric to decide on new strategies that can make the company more productive and profitable, for example, in areas like supply chain management or technology solutions.

What is COGS in the profit and loss statement?

Cost of Goods Sold is a line item on a company’s P&L statement, along with revenue, expenses, taxes, net income, and interest.

Where do COGS go in the balance sheet?

The Cost of Goods Sold is not recorded in the balance sheet. Instead, it can be found on the income statement.

Are there companies that are excluded from a COGS deduction?

Yes, some companies are excluded from COGS because they don’t sell a physical product. Some examples include accounting firms, real estate appraisers, business consultants, professional dancers, law offices, and others.