Businesses incur a range of expenses in the production of goods and services. These include direct material and labor costs that typically found within Cost of Goods Sold (COGS), as well as overhead costs not directly attributed to production.
In this article we’ll dive into what COGS is, what it tells us, and how to calculate.
What is the Cost of Goods Sold?
Cost of goods sold refers to the various costs that a business incurs in producing goods and services. These costs are directly tied to the production process, whether that is goods or services.
The cost of production is recorded as a business expense on the income statement. As a result, cost of goods sold is one of the most important business expense items that goes into ascertaining the company’s bottom line or profit metrics.
Businesses strive to keep their cost of goods sold low as one of the ways of enhancing profit margins. But an increase in COGS is not always a bad thing for a business. A company can take advantage of the increase in production costs to reduce its tax bill.
The costs incurred in producing goods and services are broadly classified into two: variable and fixed costs.
The variable costs vary depending on the amount of goods produced or services rendered. They include items like raw material costs and labor costs.
As demand for goods increases, a company would have to purchase more raw materials, incurring more material costs to produce a larger quantity of the final products.
Similarly, a service company would need to hire additional personnel to render the services when demand is high.
On the other hand, fixed costs don’t change regardless of changes in the number of goods produced or services rendered. These costs are mostly related to recurrent expenses. Fixed costs include interest payments, rent, property tax, storage costs, and factory overhead costs.
Contrary to perception, COGS does not include general selling expenses since such charges are not incurred in the production process. Consequently, items like management’s salaries and advertising expenses are never considered when calculating COGS.
Cost of Goods Sold Importance
Any business engaged in producing goods must calculate the costs of goods sold or determine the cost of the final merchandise or service rendered.
Ascertaining the costs incurred help management determine the final price of the commodity or service being rendered.
Cost of goods sold is subtracted from the revenue or sales generated on the sale of the products or services to determine the gross profit. The gross profit determines how efficiently a company manages its labor and supplies in the production chain.
Additionally, the management uses data from the cost of goods sold to determine and monitor the performance of the business.
Calculation of Cost of Goods Sold
Method One
When calculating the costs of goods sold, it is essential to consider all the costs incurred in the direct production of goods and services. Such costs include costs of raw materials, labor, and storage.
COGS = raw material costs + labor costs + Storage costs + all other direct costs
Method Two
The costs of goods sold can also be calculated using the formula:
COGS = Beginning Inventory + Purchases/Production of the Period – Ending Inventory
The beginning inventory is the total value of the inventory as of the end of the previous financial year. Essentially, it is the products not sold during the last year.
Any other production or purchases made are added to the beginning inventory. Likewise, any products not sold at the end of the year are subtracted from the sum of the beginning inventory and purchases made.
Accounting Methods for Calculating COGS
Different methods are used to calculate the cost of goods sold depending on the inventory costing method.
First in First out (FIFO)
The accounting method assumes the earliest goods to be manufactured or bought, for a trading business, are the ones sold first. Any company that uses this method ends up selling its least expensive products first, leading to much lower COGS. As a result, using the FIFO method can increase the net income over time.
Last in First Out (LIFO)
In this case, the latest goods added to the inventory end up being sold first. Businesses leveraging this method end up taking advantage of rising prices by selling goods with higher production costs.
The LIFO method usually results in a higher COGS amount and tends to decrease the net income.
Average Cost Method
This method considers the average price of all goods in stock regardless of when they were purchased. Therefore it has a smoothing effect that prevents the COGS from increasing significantly or being impacted by extreme costs.
Calculating the cost of goods sold provides valuable information on the overall production costs. Subtracting COGS from the revenue generated on the sale of the products and services rendered gives rise to the gross profit, which measures the business efficiency. The gross profit goes into paying fixed expenses, such as income taxes.
Gross Profit = Revenue COGS
For a financially sound business, the COGS should always range between 50% and 65% of the total sales generated. Anything higher than 65% raises serious doubts about the production costs as it reduces profitability in the long run.
Costs of goods sold accounting for a big chunk of the total revenues generated could be a sign of operational inefficiency. It could also signal that production costs are rising significantly and could reach an unmanageable level.
A higher than normal COGS could also point to a poor pricing strategy, such that the business is not able to recoup a significant chunk of the costs incurred in the production process.
Cost of Goods Sold Limitation
While the cost of goods sold is a significant financial metric used to ascertain operational efficiency, it can sometimes be manipulated.
For instance, accountants and managers can cook the books of accounts to allocate higher manufacturing overhead costs than what is actually incurred. By doing so, they can significantly reduce the net income to reduce their allocations for shareholders through dividends. Higher production costs also help reduce the overall tax bill given the reduced net income.
Some accountants artificially inflate the inventory levels as one of the ways of ensuring the cost of goods sold remains small. The result is usually a higher than actual gross profit margin that signals the business is doing much better than expected. The inflated net income could bolster the company’s sentiments among potential investors.
But the problem of intentional manipulation of accounting figures and other common mistakes in COGS calculation can be avoided with the use of a robust financial software.
Cost of Goods Sold vs. Operating Expenses
Cost of goods sold and operating expenses are two important financial metrics found in financial statements. But they have major differences in how they are calculated and affect profitability measures.
While COGS refer to the expenses associated with the production of goods and services sold, operating expenses (OPEX) refers to the expenses incurred in the day-to-day running of a business. Simply put, OPEX are the expense items remaining after calculating COGS. These expenses include salaries, wages, utilities, and property taxes.
Bottom Line
The cost of goods sold, or COGS, is a significant financial metric that provides valuable insights into the operational efficiency of a business.
The metric reflects the reality of the costs that a business incurs in producing goods and services. While calculating COGS is a requirement for filing income tax filing, it also helps in determining the final prices of goods and services.
Using a robust financial consolidation software allows businesses to consolidate data from multiple sources, ensuring accuracy and consistency in COGS calculations.
Automating repetitive tasks associated with COGS calculations not only saves time but also minimizes the risk of human error and ensures precise results.
Moreover, financial software provides transparency in the calculations, reducing the risk of intentional manipulation of figures by accountants. With audit trails, the software allows businesses to maintain integrity in their financial data, which helps build trust among stakeholders.
By avoiding mistakes in COGS calculations, businesses can make informed decisions to drive growth and profitability.
Frequently Asked Questions
Which companies are excluded from the cost of goods sold deduction?
Most service companies don’t incur costs for goods sold. That’s because COGS are defined as the cost of inventory items sold during a given period.
Given that services companies render services, they do not have any inventories through which they can incur the cost of goods. Such companies include accounting firms, law firms, and real estate appraisers.
Are Salaries included in calculating COGS?
Salaries and other generated administrative expenses are never included in the COGS calculation. That’s because they do not contribute directly to producing goods and services. But certain labor costs can be included, provided they can be associated with direct costs of production.
What’s the difference between the cost of goods sold and the cost of sales?
Cost of goods sold details the actual costs incurred in the production of goods and services. On the other hand, cost of sales are costs incurred in the sale of items. Such costs are mostly associated with retailers and wholesalers.
Is the cost of goods sold an asset?
The cost of goods sold is neither an asset nor a tax liability. Instead, it is an expense that a business incurs in producing a good or service. Being an expense, it impacts profitability as it must be deducted from the revenue to end up with the gross profit.
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