Before you look at your business’s profit, you need to first understand the meaning of Cost Of Goods Sold (COGS) and how to calculate it. So, in this article, you will learn everything about COGS, including how to calculate it and what they are used for.
What Is Cost Of Goods Sold In Accounting?
Another name for Cost Of Goods Sold, is cost of sales or cost of services, and it can be defined as how much it cost a company to produce their products or services.
Items Included In Cost Of Goods Sold
COGS expenses include:
- The cost of raw materials, including freight or shipping charges;
- The direct labor costs of workers producing the products;
- The cost of storage;
- Factory overhead expenses.
When calculating cost of sales, you can only include the expenses that were incurred in producing each product or service you sell (e.g., wood, screws, paint, labor, etc.). Don't include the cost of producing products or services that you don’t sell.
COGS vs. Operating Expenses
As a business owner, the term "operating expenses" is not new to you because there are chances that you’ve heard about it at some point. But, what’s the difference between COGS and operating expenses?
Operating expenses, also known as OPEX, are costs which companies incur during daily business activities to keep the business functioning. Basically, operating expenses are the opposite of COGS and they include selling, general, and administrative costs, etc.
There are chances that if an expense isn't under COGS, then it is an operating expense. Here are a couple of examples of operating expenses:
- Salaries and wages (except direct labor)
- Office supplies
How Do You Calculate Cost Of Goods Sold?
Calculating COGS of a business is quite simple if you understand the formula and where to get your data. You can calculate it by adding purchases for the period to the opening inventory and deducting the closing inventory for the same period.
Cost Of Goods Sold Formula
To find Cost Of Goods Sold, use the COGS formula stated below:
COGS = Opening Inventory + Purchases – Closing Inventory
Not certain where to get the above data to plug into the formula? Don't panic—here is a breakdown of the components of cost of goods sold and how they can be applied:
- Opening inventory: This is also known as opening stock. It is the amount of inventory remaining from the previous period (e.g., month, quarter, etc.)
- Purchases during the period: This is the total cost of what you bought during the accounting period under review.
- Closing inventory: The closing inventory or closing stock is the Inventory you did not sell during the period under review. This will be transferred to the opening inventory in the following year.
You can start calculating your Cost Of Goods Sold after you have gathered the above information. Just plug the information into the formula and you are good to go. A business may decide to calculate COGS on weekly, monthly, quarterly, or annually basis, depending on your business and goals.
Cost Of Goods Sold Example
For Instance, you want to ascertain your Cost Of Goods Sold for the quarter. You record opening inventory on January 1 and closing inventory on March 31 (end of Quarter 1). Your business has a opening inventory of $15,000. Total purchases is $7,000 for the quarter, your closing inventory is $4,000.
Since the amount was given, your work will be much easier. Just plug the information into the formula and you will get your answer. Using the cost of goods sold formula;
Cost Of Goods Sold = Opening Inventory + Purchases During the Period – Closing Inventory
COGS = $15,000 + $7,000 – $4,000
Therefore, your cost of sales for the quarter is $18,000.
Calculating Gross Profit
After calculating your cost of sales for the period, you can now proceed to find your business’s gross profit for the same period under review.
Gross profit can be defined as the revenue left over after deducting the costs of producing a product or offering a service. Use the formula below to find gross profit:
Gross Profit = Revenue – COGS
Revenue also means the sales for the period.
Still using the earlier example, your revenue for the quarter is $50,000. To find your gross profit, deduct your COGS of $18,000 from $50,000.
Gross Profit = $50,000 – $18,000
Therefore, your gross profit for the period is $32,000.
You can always check out our article on gross profit margin
Importance Of COGS In Business
Why is Cost Of Goods Sold so important to your business? It is important because it can tell you:
- How much profit you made for the period
- If there should be a change in your pricing
- If you incurred to much costs to produce the product or service
Profits: Gross Vs Net
Like I mentioned before, you can use Cost Of Goods Sold to determine your company's gross profit. Then proceed to calculate your net profit after calculating your gross profit. The net profit is the real profit. It is the amount your business earns after deducting all expenses. You can always read our article on net profit margin
Net Profit = Gross profit - Expenses
When you know your business’s profits, it can help you do the following:
- Make financial decisions
- Seek business loan when necessary
- Know when to make adjustments
As a business owner, pricing your products and services is one of your biggest responsibilities. You need to find the right price your products or services, a price that won't be too high or too low for the kind of product you selling or service you offer. Otherwise, you could liquidate your business after losing out on profits.
When it comes to pricing, to find the right price to peg your products, use your Cost Of Goods Sold. Once you know your cost of sales, you can set the right price. With your COGS, you can also determine when prices on a particular product need to increase or decrease.
For instance, let’s assume that your cost of goods sold for Product A is $10. The price of the product should be higher than $10 before you can my profit. If you price it less than $10, then you will make loss.
Your COGS can likewise determine if you’re spending a lot on production costs. The higher your production costs, the higher you need to price your product or service to make profit.
If you notice your production costs are excessively high, you can search for approaches to eliminate costs, such as finding a new supplier.
Accounting For Cost Of Goods Sold
The cost of sales can be found on your company's income statement. An income statement is one of the main financial statements, it shows a company’s profits or losses over a period.
How to calculate cost of goods sold from income statement
On the income statement, using the "T" format, COGS appears on the debit side. You can calculate cost of goods sold from income statement by deducting the closing inventory from the Cost Of Goods Available For Sale. Deduct your COGS from net sales or revenue on your income statement to arrive at your gross profit.
Your COGS is also involved in your company's balance sheet. The closing inventory appears under current assets in balance sheet. Therefore, you can use your balance sheet to calculate your closing inventory balance for the period.
Cost Of Goods Sold Account
COGS is an expense with debit balance. The COGS is a debit item because it is a expense and one of the rules of accounting states that all expenses must be debited. Expenses are costs incurred by a business during normal operations.
The difference between Cost Of Goods Sold and expenses is that the cost of goods sold includes only the costs associated with producing your sold products for the period while your expenses line includes all your other costs of running the day-to-day operations of the business.
When creating a COGS journal entry, increase expenses with a debit, and decrease them with a credit.
Changes In COGS
There can be changes in the Cost Of Goods Sold throughout the accounting period. COGS depends on changing costs and the inventory methods used.
The three inventory costing methods are:
- FIFO (first in, first out): First goods manufactured or purchased are the first to be sold.
- LIFO (last in, first out): Last goods manufactured or purchased are the first to be sold.
- Average cost: Determine the average cost per inventory.
Your type of inventory will tell the inventory costing method you will use. The IRS sets specific rules for which method you can use and when you can make changes to your inventory cost method.
If you are using the FIFO method, the first goods you will sell are the ones you produced or purchased first. This means that you will first sell your least expensive inventories. This will lead to recording a lower cost of sales.
When you are using the LIFO method, you sell the last goods you purchased or produced first. With LIFO, you might have a higher COGS.
To find your Cost Of Goods Sold with the average method, you take an average of your inventory. This keeps your COGS more accurate than when you are using the FIFO or LIFO methods.