How to Calculate COGS (Cost of Goods Sold)
Understand how to accurately determine your Cost of Goods Sold (COGS) for effective financial analysis and business performance.
Cost of Goods Sold (COGS) is a fundamental accounting measure for businesses that sell physical products. It represents the direct costs specifically tied to the production of the goods a company sells during a particular period. This figure is a direct expense on a company’s income statement, playing a significant role in calculating gross profit. Understanding COGS helps businesses assess their profitability from core operations before considering other expenses.
Components of Cost of Goods Sold
Calculating the Cost of Goods Sold involves identifying and aggregating specific direct costs incurred in the production process. These costs are categorized into direct materials, direct labor, and manufacturing overhead. Accurate classification is essential for precise COGS calculation.
Direct materials are the raw materials that become an integral part of the finished product. For instance, the lumber used to build a wooden chair or the fabric and thread used to make a shirt are considered direct materials.
Direct labor refers to the wages paid to employees who are directly involved in the manufacturing or production of the goods. This includes the compensation for workers on an assembly line. Their efforts directly contribute to transforming raw materials into finished products.
Manufacturing overhead includes indirect costs associated with the production process that cannot be directly traced to specific units. Examples include the rent for the factory building, utilities consumed by the production facility, and depreciation on manufacturing equipment. Indirect labor, such as the salary of a factory supervisor or maintenance staff, also falls into this category.
Inventory Valuation Methods
The method a business uses to value its inventory directly impacts the Cost of Goods Sold and the reported value of remaining inventory. Three primary methods are commonly employed to assign costs to inventory: First-In, First-Out (FIFO), Last-In, First-Out (LIFO), and Weighted-Average Cost. Each method makes a different assumption about the flow of inventory costs.
The First-In, First-Out (FIFO) method assumes that the first goods purchased or produced are the first ones sold. Under this method, the costs associated with the oldest inventory are expensed as COGS, while the costs of the most recently acquired items remain in ending inventory. This approach often aligns with the physical flow of goods, especially for perishable items.
Conversely, the Last-In, First-Out (LIFO) method assumes that the last goods purchased or produced are the first ones sold. This means the costs of the most recent inventory acquisitions are recognized as COGS, and the costs of older inventory remain in ending inventory. LIFO is permissible under U.S. Generally Accepted Accounting Principles (GAAP) but is generally not allowed under International Financial Reporting Standards (IFRS).
The Weighted-Average Cost method calculates an average cost for all available inventory items during a period. This average cost is then applied to both the units sold (COGS) and the units remaining in ending inventory. This method tends to smooth out cost fluctuations, as it does not prioritize any specific purchase order but rather uses an average of all costs incurred.
Applying the COGS Formula
Calculating the Cost of Goods Sold involves a straightforward formula that brings together the values derived from inventory. The fundamental COGS formula is: Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold.
Beginning inventory represents the value of unsold goods a company had on hand at the start of an accounting period. This figure is typically the ending inventory balance from the immediately preceding accounting period.
Purchases include the cost of all new inventory acquired by the business during the current accounting period. This encompasses not only the purchase price of the goods but also any additional costs incurred to bring them to their present location and condition, such as freight-in charges.
Ending inventory is the value of unsold goods remaining at the close of the accounting period. This amount is subtracted from the sum of beginning inventory and purchases to determine the cost of the goods that were actually sold. These values are derived from direct materials, direct labor, and manufacturing overhead, then valued using one of the chosen inventory valuation methods.