Calculating the Cost of Goods Sold
For manufacturers, "cost of goods sold" (COGS) is the cost of buying raw materials and manufacturing finished products. For retailers, it's the cost of obtaining or buying the products sold to customers. If the company is in a service industry, COGS is the cost of the service it offers.
COGS can help companies work out how much they should charge for their products and services, and the level of sales they need to sustain in order to make a profit.
The price paid for products is particularly crucial to retailers, as it is often their greatest area of expenditure. But all businesses can benefit from an analysis of COGS, as it can highlight ways of improving efficiency and cutting expenditure.
COGS is closely related to inventory—which is treated as potential revenue in relation to tax—so it's also essential information for a company's profit and loss account (income tax return).
COGS describes the direct costs involved in producing products or services. At its simplest, the calculation takes the value of inventory at the beginning of a specified period, plus the value of purchases, and subtracts the value of inventory at the end of the period. Expressed as a formula, it looks like this:
Suppose the opening inventory is $30,000 and purchases during the period are $50,000. At the end of the period, inventory is $15,000—so:
The value of inventory may be calculated using a First In First Out (FIFO) policy—which takes its original cost—or a Last In First Out (LIFO) policy, which takes its present (usually higher) cost. It's important to know which method is being used, especially if inflation rates are running high, as it could make a significant difference to the result.
In manufacturing companies, direct costs may include such things as: labor costs and workforce benefits; raw materials and raw materials inventory; energy costs related to production; shipping and warehousing; factory overheads; and depreciation of equipment and machinery.
Suppose the opening inventory is $25,000 and purchases during the period are $45,000. The cost of direct labor is $15,000, and raw materials plus energy costs are $10,000. Total product expenses are therefore 25,000 + 45,000 + 15,000 + 10,000 = $95,000. At the end of the period, inventory is $10,000, so:
It's usually less complicated in the retail sector, where COGS is simply the amount spent on buying or acquiring products that are sold on to the customer.
The tax rules allow retailers to estimate COGS because taking inventory is such a labor-intensive activity and can be prone to error. Most retailers take last year's net sales and gross profit margin (which they use work out a cost ratio) in order to estimate COGS.
Suppose net sales are 100%, and the gross profit margin is 35%. The cost ratio is 100 – 35 = 65%. So COGS is calculated as follows:
Opening inventory = $15,000
Purchases = $30,000
Net sales = $35,000
Cost ratio = 65%
- It's essential that a company stays on top of its inventory and recognizes its value, if COGS is to be meaningful.
- Goods returned must be taken into account when calculating COGS, because they affect the value of inventory.
- Different methods of accounting for inventory will give the same answer but costs may be allocated differently.
- Because indirect costs like administration or promotions are not involved in production, they should not be included in COGS calculations.
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