What is the Cost of Goods Sold?
Cost of Goods Sold, or simply COGS is a concept in management that helps in establishing the amount of money incurred in producing goods that a business sold within a defined timeframe. In summary, it’s a calculation of all the costs incurred in selling a number of unit products.
There are a few factors that could make the calculation of goods sold challenging. These factors range from the number of goods manufactured, the complexity of the production process, and the factors of production involved, to name a few.
It’s important to note that this calculation, however, doesn’t take into consideration the expenses your business incurred in the manufacturing of goods that were not sold within the stipulated accounting period.
Why is it important to calculate the Costs of Goods Sold?
COGS is an essential tool in management because it helps business managers analyze and figure out the best ways to control purchasing and payroll expenditures. Stakeholders also use it to determine the margins of the business and thereby know how much money should go into covering the expenses, taxes, salaries, and dividends.
Besides, COGS is a requirement in both income statements (help manufacturers and retailers arrive at the gross margin) and calculation of tax returns. Also, subtracting COGS from your total revenue reduces the amount of tax your business has to pay and vice versa, so you must get the cost of goods sold right.
At Brief, we understand what COGS means to your business, so if you don’t know how to calculate it, here is a reliable step-by-step guide to help you out.
Calculating the Cost of Goods Sold
Before we get into the calculations, you’ll need some preliminary information. The information includes; the beginning and ending inventory values, the costs of inventory purchased during the accounting period, and an inventory evaluation method that’s most suitable for your business.
While your in-house accounting team can easily calculate the cost of goods sold, for business income tax return purposes, it’s best done by either a CPA or a tax professional.
The Basic Components for calculation of Costs of Goods Sold
- Inventory value at the beginning of the financial year
- Cost of inventory purchased during the financial year
- Subtract the value of inventory at the end of the financial year
Example
Say,
- Cost of starting inventory=$12,000
- Add Cost of inventory purchased during the financial year=$4,500
- Subtract the value of ending inventory=3,500
Cost of Goods Sold=$12,000+$4,500-$3,500=$13,000
However, there are two angles to the Costs of Goods Sold; direct costs and indirect costs. To get an accurate COGS, you need to determine and factor in both the direct and indirect costs into your calculations.
Direct Costs
These are usually overhead costs that have a direct bearing on the cost of production. They include but not limited to:
- The cost incurred on buying goods for resale
- Cost of raw materials
- Cost of parts used in assembling products
- Cost of packing produced goods
- Cost of supplies for the production of goods
Indirect Costs
These are derived costs; they cannot be directly attributed to the production process. Indirect costs include but not limited to:
- Salaries paid to employees
- Rent paid by the company
- Storage/warehouse charges
- Utility bills paid
- Depreciation of production machinery
- Parking costs
Facility Costs
Depending on the type of facilities your business uses for the production of goods, the costs involved might be easy or difficult to determine. Either way, the facilities’ costs should be factored in when calculating the costs of goods sold.
Facilities costs are usually the most challenging costs to determine. It’s at this point that a certified public accountant would be of help. A CPA would be best placed to determine the percentage of facility costs that went into the manufacture of a unit product, for the financial year under consideration.
Inventory Costs at the beginning of the Financial Year
The inventory at the start of an accounting period must be equal to the value of inventory at the end of the previous accounting period. Unless the company is in its first year of operation, if the values differ, it’s considered an error in accounting and the accountant will be required to explain the difference.
The Inventory, in this case, includes goods in stock, raw materials, goods already produced, work in progress, and supplies.
Purchases of inventory items during the financial year
Many manufacturing companies add to their stock all through the year. This is where bookkeeping comes in handy. You must keep track of every stock item added to your company’s inventory during the year.
For instance, if you purchase goods for resale or raw materials, be sure to keep the invoices—or receipts. If you put some work into the inventory items added, also be sure to determine the cost of the work and add it to the cost of the inventory purchased.
Value of Inventory at the end of the financial year
Value of the ending inventory is perhaps the easiest to determine. The value is determined by a physical count of items that remain at the end of an accounting period and multiplying their number by cost per unit product. This gives you a common value for ending inventory for the current financial year and the starting inventory for the next.
The Cost of Goods Sold
With all that in mind, it becomes easy to implement the COGS formula.
COGS = Beginning Inventory + Purchases During the Period (including direct and indirect costs of goods, and the facility costs) – Ending Inventory.
Disclaimer: This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice.
