What Is Cost of Goods Sold?
Cost of goods sold or COGS is the total cost required to produce a product or a service, including materials and labor. Calculating your cost of goods sold (or COGS for short) is an important step in determining the profitability of your company. Also known as simply “cost of goods” or “cost of sales,” COGS is a crucial number on the profit and loss statement of inventory-based companies. Without this number, you cannot determine your gross profit, which is a critical metric to know when you’re trying to maximize the profitability of your business.
Knowing your cost of goods sold is one of the foundations of good business accounting. Although some service businesses show cost of sales on their profit and loss statement, for the purposes of this article we are going to focus on inventory-based businesses. Specifically, we are going to look at what cost of goods sold is, how to calculate cost of goods sold, and some common arguments regarding what is included in cost of goods sold… and what isn’t.
What Is Cost of Goods Sold?
Cost of goods sold is an accounting term that stands for the direct cost of the products sold by a company, including the cost of the materials as well as labor needed for production. In retail businesses, cost of goods is the cost of the inventory the business sells. This is usually accounted for on a sale-by-sale basis, often using a perpetual inventory system within the business’s point of sale software.
Here’s an example: Let’s say you sell snorkel and goggle sets at a stand on the beach. Because you have a captive audience, you can sell these snorkel and goggle sets for $20 each. If you sell 10 sets before noon, you will have made $200 in sales.
But you had to pay for those snorkel and goggle sets you sold. Chances are, you paid your supplier for those sets before they shipped them to you. If your supplier charged you $5 for each snorkel and goggle set, your cost of goods sold for the morning is $50 (10 snorkel and goggle sets sold x $5 per set = $50.) Because you are using a perpetual inventory system, you know the exact cost of each set you sold. You can also easily determine your gross profit on your sales (in this case, $150).
In a manufacturing company, cost of goods sold includes all of the direct costs that go into the production of the product. This includes not only raw materials but also production labor. Sometimes a manufacturer will also include burdened overhead costs, like a portion of the rent or mortgage on the building where the product is made, to cost of goods sold. More on this a little later.
To continue with the snorkel and goggle example, the manufacturer that makes the sets will need to account for the plastic, latex, and glue that goes into making the sets, as well as the wages paid to the workers who make them. If they are selling the sets to beach stands for $5/set, they must make sure their cost per set is less than $5 in order to be profitable.
How to Calculate Cost of Goods Sold
If you are a retailer using a point of sale software and perpetual inventory system, your cost of goods sold calculation is going to be pretty straightforward and easy to calculate. In fact, your point of sale system will do most of the work for you—no accounting book required.
The following are the steps to take to make sure your cost of goods sold calculation is correct (the exact steps you follow will depend on your point of sale system):
- Whenever new merchandise is received, compare the invoice for the merchandise to the current cost per piece in your point of sale system.
- Receive the merchandise into the inventory component of your point of sale system. Include any shipping costs—“freight in” is considered part of cost of goods sold—and update the cost field on your receiving log, if necessary.
- Your point of sale system should then update your cost per item. This cost will automatically be applied to each sale.
- Determine if you need to increase your pricing on each item to maintain profitability.
But what if you are a manufacturer or a retailer who doesn’t use a perpetual inventory system? You can still determine your cost of goods sold using the following formula:
Beginning Inventory + New Inventory Purchased – Ending Inventory = Cost of Goods Sold
If you use this cost of goods sold formula, you will have to conduct a periodic physical inventory of your merchandise or raw goods. This is typically done annually, but some businesses conduct inventory quarterly or even monthly.
(As a side note, it’s a good idea to conduct a periodic physical inventory even if you are using a perpetual inventory system. This will help you account for inventory shrinkage due to theft or spoilage.)
Inventory Valuation Methods
We would be remiss if we didn’t take a little bit of time to look at the most common inventory valuation methods. Why? Because the method you use can have a significant impact on your cost of goods sold calculation.
There are three inventory valuation methods most commonly used by both retailers and manufacturers.
1. First In, First Out (FIFO)
This inventory valuation method assumes the first inventory purchased will be the first used. FIFO inventory valuation is often used when the inventory is perishable (think of milk at the grocery store) or when stock is otherwise easily rotated.
Here’s an example: Let’s say you purchased 50 snorkel and goggle sets at $5 each. You are down to your last 10 sets and place an order to replenish your stock. Due to a latex shortage, those same sets now cost $7 each. When you do your cost of goods sold calculation, you will assume the next 10 sets you sell cost $5 each, and then you will apply the $7 cost to each subsequent set you sell.
2. Last In, First Out (LIFO)
The LIFO inventory valuation method is often used when the stock isn’t easily rotated or when stock levels get really low before they are replenished. LIFO inventory valuation is no longer used in most countries (in fact, it has been banned everywhere except the United States) because it can dramatically distort inventory (and cost of good sold) figures.
Following the example from above, if you were using the LIFO inventory valuation method, you would immediately begin applying the $7 cost to your snorkel and goggle sets, even though you purchased 10 of those sets at $5 each.
3. Average Cost
The average cost method is the easiest inventory valuation method to apply. It is also the one most commonly used when a business sells many of the same item and tracking each item individually doesn’t make sense.
Here’s how you would use the average cost method to determine the value of your snorkel and goggle sets, assuming you reordered 50 sets at the new price of $7:
10 sets at $5 ($50) + 50 sets at $7 ($350) = 60 sets at a total cost of $400
Average cost per set is $6.67 ($400 / 60 sets)
Speak with your accountant before choosing an inventory valuation method. Once adopted, you must stick with the same inventory valuation method for the sake of consistency, so you want to choose the best method and accounting formula for your business.
Direct Labor Costs
If your business manufactures a product—like snorkel and goggle sets—you must include your direct labor costs in order to reach your true cost of goods sold. The easiest way to do this is to look at your payroll reports.
If you paid your workforce $10,000 last month, you would add that $10,000 to your cost of goods sold. If your workforce produced 20,000 snorkel and goggle sets during that month, your direct labor cost is $0.50/set.
If your workforce spends part of their time on the manufacturing floor and part of their time in non-production duties, consider using a time tracking software that lets you assign different wage categories to each employee. Even if you pay them the same hourly wage for non-production duties, this will allow you to quickly determine what portion of each worker’s wages should be applied to cost of goods sold as opposed to overhead costs.
What Belongs in Cost of Goods Sold… and What Doesn’t
There are some common debates about what belongs in cost of goods sold and what doesn’t. For example, some business owners contend their merchant service fees are a direct cost of sales, which wouldn’t exist if they didn’t accept credit cards for purchases.
Other business owners—especially manufacturers—want to burden a portion of their overhead costs to cost of goods sold. After all, their office staff does provide vital support that makes production run smoothly, and they pay rent on their building, which houses the manufacturing facility. Doesn’t it make sense to assign part of those wages and rent costs to cost of goods sold?
As much as possible, you want to keep overhead costs out of your cost of goods sold calculations. While it might make sense that a portion of these costs do directly relate to the production or sale of your product, trying to assign a portion of your overhead costs to your cost of goods sold can over-complicate your accounting without any real benefit.
In other words, make cost of goods sold about direct costs only. This will help you get a clearer picture of your business’s gross profit, which in turn will help you maximize your profitability.
Calculating Cost of Goods Sold for Your Business
Cost of goods sold is a vital calculation for any inventory-driven business. Once you know your cost of goods sold, you can easily determine your gross profit, and increasing your gross profit even 1% can have a profound impact on your bottom line.
Check with your accountant to choose the best inventory valuation method for your business. Doing this first will help you complete your cost of goods sold calculation correctly, which will in turn result in accurate financials to help you make sound business decisions.
Finally, keep it simple. Although you can make a case for including a portion of your overhead costs in your cost of goods sold calculations, limiting cost of goods sold to direct costs will give you a more accurate picture of what it actually costs you to produce your product or sell your inventory.