How to Calculate Cost of Goods Sold (COGS)
Gain clarity on Cost of Goods Sold (COGS). This guide covers its fundamental elements, precise calculation, and significant influence on your company's financial health.
Gain clarity on Cost of Goods Sold (COGS). This guide covers its fundamental elements, precise calculation, and significant influence on your company's financial health.
Cost of Goods Sold (COGS) represents the direct costs a business incurs to produce the goods it sells. Accurately calculating COGS is necessary for financial reporting, setting pricing strategies, and impacting tax calculations. It is a key component in determining gross profit, which measures a company’s production efficiency.
Cost of Goods Sold includes all direct expenses specifically tied to the creation or acquisition of products intended for sale. These are costs that would not be incurred if no products were made or purchased. Distinguishing these direct costs from other business expenditures, known as operating expenses, is a foundational aspect of financial accounting. Operating expenses, such as administrative salaries or marketing costs, are necessary for running a business but are not directly linked to product production.
The primary components that make up COGS are direct materials, direct labor, and manufacturing overhead. Direct materials are the raw materials that become an integral part of the finished product, such as wood for furniture.
Direct labor includes the wages paid to employees directly involved in the manufacturing process or assembly of the product, like hourly pay for assembly line workers. Manufacturing overhead encompasses indirect costs associated with the production process, such as factory rent, utilities for the production facility, and depreciation of manufacturing equipment.
The fundamental formula for calculating Cost of Goods Sold brings together inventory values from different points in an accounting period. The formula is: Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold.
Beginning inventory is the total value of goods on hand at the start of an accounting period. This figure is the same as the ending inventory from the immediately preceding accounting period.
Purchases refer to the cost of all additional inventory acquired by the business during the accounting period. For manufacturers, this includes the cost of raw materials converted into finished goods, while for retailers, it represents the cost of merchandise bought for resale. Ending inventory is the value of unsold goods that remain on hand at the close of the accounting period.
The value assigned to ending inventory significantly influences the calculated Cost of Goods Sold, and consequently, a business’s reported gross profit and taxable income. Businesses must select an inventory accounting method and apply it consistently each year.
One common method is First-In, First-Out (FIFO), which assumes that the first goods purchased are the first ones sold. Under FIFO, the oldest costs are assigned to the Cost of Goods Sold, while the remaining inventory is valued at the most recent purchase costs. In an environment of rising costs, FIFO results in a lower COGS and a higher ending inventory value, leading to higher reported net income.
Conversely, the Last-In, First-Out (LIFO) method assumes that the last goods purchased are the first ones sold. Most recent costs are expensed as COGS, and older costs remain in ending inventory. During periods of rising costs, LIFO results in a higher COGS and a lower ending inventory value, which translates to lower reported net income and reduced taxable income. While LIFO is permitted under U.S. Generally Accepted Accounting Principles (GAAP), it is not allowed under International Financial Reporting Standards (IFRS).
The Weighted-Average Method calculates the average cost of all goods available for sale during the period. This average cost is then applied to both the Cost of Goods Sold and the ending inventory. This method tends to smooth out cost fluctuations, providing values for COGS and ending inventory that fall between those determined by FIFO and LIFO.
Calculating Cost of Goods Sold requires gathering specific financial data and applying the chosen inventory valuation method. The process begins with identifying the beginning inventory, which is the value of goods on hand at the start of the period. For example, if a business had $20,000 worth of inventory on January 1st, this would be its beginning inventory.
Next, determine the total cost of purchases made during the accounting period. If the business purchased an additional $9,000 in goods throughout the quarter, this amount is added to the beginning inventory. The sum of beginning inventory and purchases represents the total cost of goods available for sale.
To find the ending inventory, a physical count or perpetual inventory records are used, and the value is determined by applying an inventory valuation method like FIFO. For instance, if the business sold items such that the remaining ending inventory on March 31st is valued at $5,000 using the FIFO method, this figure is then subtracted.
Using the COGS formula (Beginning Inventory + Purchases – Ending Inventory), the calculation would be $20,000 (Beginning Inventory) + $9,000 (Purchases) – $5,000 (Ending Inventory) = $24,000. The Cost of Goods Sold for that quarter would be $24,000.