Definition of the cost of goods sold
The cost of goods sold (COGS) is the cost of goods sold by a company. It takes into account the material and labor costs that are directly related to this good and for a specific accounting period.
As a company that sells products, you need to understand the cost of making those products. This is where the Goods Sold Formula (COGS) comes into play. In addition to calculating the cost of producing a good, the COGS formula can also reveal profits for a billing period when price changes are required or if you need to reduce production costs.
Whether you introduce yourself as a business owner or a consumer, or both, knowing how to calculate the cost of the goods you sell can help you better educate yourself about the products you buy or make.
What is the price of sold goods?
The cost of goods sold is the cost of goods sold by a company. It includes the material and labor costs directly related to this good. However, this does not include indirect expenses such as selling and distribution costs.
What is the formula for the cost of goods sold?
When you sell a product, you need to know the cost of its production over a specific period of time, which can be a month, quarter, or year. You can do this using the cost of goods sold. It's a simple calculation that takes into account opening and closing inventory, as well as purchases made during the billing cycle. Here is a simple breakdown of the cost of the goods sold:
COGS = Opening Inventory + Purchases During Period – Closing Inventory
How do you calculate the cost of goods sold?
In order to calculate the manufacturing costs of the goods sold, you have to determine your opening inventory – for example your goods, including raw and auxiliary materials – at the beginning of your accounting period. Then add the new inventory purchased during that period and subtract the ending inventory – i. H. the inventory that is left at the end of your billing cycle. The expanded COGS formula also takes into account returns, allowances, discounts, and freight charges, but we'll stick to the basics in this explanation.
Going through it step by step can help you understand the COGS formula and determine the true cost of the goods sold. How to do it:
Step 1: Identify direct and indirect costs
Whether you make products or resell them, the COGS formula allows you to subtract all associated costs. The first step is to distinguish the direct costs that go into the COGS calculation from the indirect costs that don't.
Direct costs are the costs associated with making or purchasing a product. These costs can fluctuate depending on the level of production. Here are some examples of direct costs:
Production workers wages
Indirect costs go beyond the costs associated with making a product. They include the costs associated with maintaining and operating the company. Fixed indirect costs such as rent and fluctuating costs such as electricity can arise. Indirect costs are not taken into account in the COGS calculation. Here are some examples:
Bookkeeping and payroll
Benefits and benefits for employees
Step 2: determine the opening balance
Now is the time to determine your starting inventory. The opening inventory is the amount of inventory that is left over from the previous period, which can be a month, a quarter, or a year. Starting inventory is your trading goods, including raw materials, consumables, and finished and unfinished products that were not sold in the previous period.
Note that your starting inventory cost for this period should be exactly the same as your ending inventory cost from the previous period.
Step 3: Total the items added to your inventory
Now that you have your initial inventory, you also need to consider all inventory purchases throughout the period. It is important to keep track of shipping and manufacturing costs for each product, which increases inventory costs over the period.
Step 4: determine the ending inventory
Closing inventory is the value of the goods that is left over in the current period. It can be determined from a physical inventory of the products or an estimate of their quantity. Closing inventory costs can also be reduced if an inventory is damaged, out of date, or worthless.
Step 5: Plug it into the equation for the cost of goods sold
Now that you have all the information to calculate the cost of the goods sold, all you need to do is paste it into the COGS formula.
An example of the formula for the cost of goods sold
For example, suppose you want to calculate the cost of goods sold over a monthly period. After considering the direct cost, you find that you have an opening balance of $ 30,000. During the month, you buy additional inventory worth $ 5,000. Finally, after doing an inventory of the products at the end of the month, you realize that there is a closing inventory valued at $ 2,000.
Using the equation of goods sold, plug in these numbers as such and find that your cost of goods sold is $ 33,000:
COGS = Opening Inventory + Purchases During Period – Closing Inventory
COGS = $ 30,000 + $ 5,000 – $ 2,000
Accounting for the manufacturing costs of the goods sold
There are several accounting methods that are used to keep track of inventory levels during an accounting period. The chosen accounting method can influence the value of the manufacturing costs of the goods sold. The three main methods of accounting for the cost of goods sold are FIFO, LIFO, and the average cost method.
FIFO: First In, First Out
The first-in-first-out method, also known as a FIFO, involves selling the earliest goods bought first. As the prices of goods tend to rise, the FIFO method would mean that the company would sell the cheapest item first. This leads to a lower COGS compared to the LIFO method. In this case, the net income increases over time.
LIFO: Last In, First Out
The last-in-first-out method, also known as LIFO, involves selling the most recently added goods first. In the event of a price increase, a company using the LIFO method would essentially sell the goods with the highest cost first. This leads to a higher COGS compared to the FIFO method. With this method, the net income tends to decrease over time.
Average cost method
With the average cost method, a company uses the average price of all goods in stock to calculate initial and final storage costs. This means that the COGS are less affected by higher costs when purchasing inventory.
Considerations about the cost of goods sold
There are a few other factors to consider when calculating the cost of goods sold.
COGS vs. operating costs
Entrepreneurs are likely familiar with the term "operating costs". However, this should not be confused with the cost of the goods sold. While both are business expenses, business expenses are not directly tied to the production of goods.
Business expenses are indirect costs that keep a business running and can include rent, equipment, insurance, salaries, marketing, and office supplies.
COGS and inventory
The COGS calculation focuses on your company's inventory. Inventory can be purchased or self-made items, which is why manufacturing costs are only sometimes included in the direct costs of your COGS.
Cost of sales vs. COGS
When calculating the COGS, it must also be taken into account that these are not identical to the cost of sales. The cost of sales takes into account some of the indirect costs related to the sale, such as: B. Marketing and Sales, while COGS does not consider indirect costs.
Exclusions from the COGS deduction
Since service companies don't have inventory to sell and COGS takes inventory costs into account, they can't use COGS because they don't sell a product – they would instead charge the cost of services. Examples of service companies include accounting firms, law firms, consultants, and real estate appraisers.
Start Your Small Business Budget Today!
Setting up a budget is easy in the Mint app!
The bottom line
Running a business requires many moving parts. To ensure that a business is making a profit and everyone is getting a fair salary, business owners should have a comprehensive view of the costs associated with their goods sold. Following this step-by-step guide to learn how to use the formula for the cost of goods sold is a good place to start. As always, it is important to consult an expert such as an accountant with these calculations to ensure that everything is taken into account.
Sign up for Mint today
From budgets and bills to free creditworthiness and more:
Discover the effortless way to stay on top of things.
Learn more about security