What is cost of goods sold?
Cost of goods sold (Cogs) is a critical business measure that helps drive profitability in your company, product or department.
It describes all the expenses directly related to the production of your company’s goods. Understanding your Cogs helps you stop leaking profits from day to day – and could ultimately mean the difference between profitability and failure.
You can also deduct Cogs from your taxes, so it is important to track these expenses closely.
There is one simple formula for calculating Cogs. But there are different ways of accounting for each cost within it and which method you use can significantly impact your gross profit and tax liability.
Why Cogs is important for businesses
When you move from simple, backward-looking bookkeeping to proper accounting practices, Cogs is one of the key performance indicators (KPIs) that you start tracking closely. Measuring Cogs alongside other critical indicators – such as cash flow and gross profit – helps ensure your business runs profitably, smoothly, and sustainably. For most growing small and
medium-sized enterprises (SMEs), calculating, tracking and analyzing these measures via their cloud accounting software is essential.
Any successful business must understand its indirect costs such as marketing, administration, and office supplies. But, if you manufacture or sell a product, you must also have an in-depth understanding of direct expenses – the portion of your costs that relate directly to providing your product – and be ready to respond to any short or long-term changes in this figure.
You need to know Cogs to calculate your gross profit margin – sales minus Cogs – which is critical in many businesses. Factoring in your indirect costs then helps you calculate your net profit.
Amy LaSala, valuations manager at Vision Point Capital, says: “Business owners and investors use the Cogs metric to help manage the bottom line. Cost of goods and net income have an inverse relationship, meaning if Cogs increases, net income decreases. Generally, you should keep Cogs as low as possible to increase your profits to shareholders. You should also review inventory purchases regularly and or shop for new suppliers to keep your cost of goods down.”
Understanding Cogs makes it easier to identify cost-saving measures that can boost profits. For example, it can help you find ways to reduce your inventory and wholesale costs, measure inventory turnover, and minimize inventory holding costs. It can also protect against leaking profits, which are a danger to many businesses.
Let’s look at what this could mean in a fast-moving, high-turnover business such as a restaurant. Most businesses need to keep on top of their gross margins. But in a restaurant, you need to check them weekly at least. It’s no good turning over $1 million on the assumption your margin will be 75%, if it actually fell to 65% last month because your staff were pilfering goods from the kitchen, or the cost of popular ingredients has spiked due to a supply shock you weren’t aware of.
Even the smallest change in margin makes a huge difference. For example, if you are turning over $1 million a year, the difference between 60% and 61% margin is $10,000 less profit.
Many companies now use technology to keep a daily or real-time eye on their Cogs. This can help you see quickly if there’s a problem and where it stems from.
Fast-moving businesses such as shops and cafés can even use analyze Cogs alongside sales figures per item daily. This shows which items are most popular and profitable now, or at different times of the week, month or year. These figures can then guide pricing and help you offer the right products at the right time to maximize profits.
Small business owners often make such decisions based on gut instinct or personal taste. But, no matter how experienced you are, you could be wrong – precise, real-time figures help ensure you are making more effective decisions.
How to calculate cost of goods sold
To calculate Cogs, take the cost of initial inventory and add additional direct costs during the period you are measuring. Then, subtract the value of the inventory yet to be sold. Written as a formula, it is:
Cogs = (initial inventory + additional costs) – ending inventory (goods not yet sold).
For all parts of the equation, use the cost prices you pay – not prices before discount, and not the retail or resale value.
Make sure you accurately measure your inventory at the start and end of the year – plus any inventory you buy throughout the year. Initial and ending inventory should tally, so if you are claiming tax deductions for Cogs, you need to explain any difference on your tax return.
Calculating Cogs can be complex for any firm but the more manufacturing you do, the more complex it gets. If you are a merchant, inventory is the cost of the merchandise you have ready to sell to customers. If you are a manufacturer or producer, it includes the total cost of raw materials, work in process, finished goods, and supplies used in making the goods. It can also include shipping of parts, freight-in, storage, and factory overhead used to support production directly.
Costs that are excluded from Cogs include insurance and the costs of running your legal, sales, marketing, administration and HR departments.
How to account for cost of goods sold
In the US, Cogs are tax-deductible for any product you manufacture yourself or buy with intent to resell – so includes manufacturers, wholesalers and retailers. Any that provide services – such as doctors, lawyers, and carpenters – cannot claim the Cogs deduction unless you also sell or charge for the materials and supplies in your business.
While Cogs are costs, they are usually accounted for separately from other expenses to allow a clearer picture of your company’s finances. They often go first in income and cashflow statements.
Companies can choose from several accounting methods to decide the cost of each item in Cogs, and the method they choose can significantly impact Cogs, profitability and tax liability. Methods include first in first out (FIFO); last in first out (LIFO); weighted average; and special identification.
Under FIFO, the business assumes the earliest goods bought or manufactured are sold first. When prices are rising, a company using the FIFO method will sell its least expensive products first, which translates to a lower cog compared to LIFO. Hence, the net income using FIFO increases over time.
Bryan Sharpe, senior accountant at Solar Panels Network USA, says: “FIFO is often used where inventory turns over quickly, such as retail. The main advantage of this method is that it matches expenses with revenue, which gives a more accurate picture of profitability. However, it can also lead to higher taxes if Cogs has increased over time.”
With LIFO, the latest goods added to the inventory are sold first. This means higher cost goods are sold first. Bryan says businesses with slow-moving inventory, such as manufacturing, often use this method. It usually results in lower taxes, since the most recent items purchased typically have the highest cost. However, it can also lead to discrepancies between actual and reported inventory levels.”
Weighted averaging uses the mean price of all goods in stock, regardless of purchase date. This smooths Cogs through the period and reduces the impact of price spikes. It can work well for mass-production items.
Bryan says: “Weighted averaging is relatively simple to calculate and doesn’t require businesses to track inventory levels as closely. However, it can lead to fluctuations in reported profits and doesn’t always give an accurate picture of actual costs.”
The special identification method uses the specific cost of a merchandise unit, so you know precisely which items you have sold and the exact cost. Companies tend to use it if they sell unique or luxury items like cars and real estate.
Bryan says: “Special identification is often used when there are a limited number of units or when certain items are more expensive than others. It gives businesses more control over their costs. However, it can also be more time-consuming to track and manage.”
So there are many complex calculations and decisions to make. Accounting software solutions make it much easier to calculate Cogs and use it to best effect in your business. You’ll need reliable cloud accounting software so you can access the information you need all in one place, in real time and on any device. This enables you to tackle challenges and opportunities relating to Cogs as they happen, rather than at the end of the quarter or year, which may be too late.