In accounting terms, Cost of Goods Sold is simply the cost of an item to a retailer, manufacturer or distributor. COGS is a form of expense, and is recorded in an income statement.
There are two ways to calculate Cost of Goods Sold, which we will look at in this article. First though, let’s look at what COGS is…
Cost of Goods Sold (COGS)
COGS – sometimes also called Cost of Sales – is the term applied to the cost of any goods that are either purchased or manufactured to be sold. COGS have a direct impact on a business’s profits (or losses).
Listed on a business’s income statement, either under the heading of “sales” or “income”, COGS are an important factor in performance.
Tax and COGS
According to the IRS, tax reporting of COGS is an obligation for all businesses that sell products, so that they can write off the expense. Since COGS can be used to reduce tax liability, it is also in a business’s interest to declare.
Any small business with average gross revenues below $25m in the previous 3 years needs to report their COGS, requiring absolute accuracy in order to prove the costs associated with all goods purchased.
As Cost of Goods Sold increases, a business’s profits are reduced; so keeping COGS to a minimum is crucial.
What is Included in Cost of Goods Sold?
A number of elements combine to form Cost of Goods. These include:
In this formula, “beginning inventory” is the value of inventory and the start of the reporting year (which is in fact calculated at the end of year before). “Cost of goods”, as you may expect, is the cost of all goods purchased or produced through the year. “Ending inventory” is defined as the value of all inventory at the end of the year.
FORMULA 2
In the second method, any change in inventory is used to adjust the Cost of Goods. Let’s look at an example:
At the start of the year, Bob’s Hardware Store places an order for 100 ladders. By the end of the year, Bob’s inventory has increased by 20 ladders. In this case, the cost of 480 ladders is the Cost of Goods Sold.
Had Bob’s inventory fallen by 30 ladders at the end of the year, then the cost of 130 ladders would be the Cost of Goods Sold.
Other Uses for COGS
When a business wants to determine its inventory turnover (the number of times they sell or replace their inventory in a given period) COGS can be used for this purpose. It is sometimes also used to determine gross margin.
Variable Inventory Cost and COGS
With so many factors involved in determining the Cost of Goods Sold, it’s no surprise that it is not a number that remains static over the course of a year. In order to accurately report COGS, these fluctuations need to be accounted for, and there are three ways to do this:
- Cost of raw materials
- Cost of any parts used
- Labor costs
- Shipping and transport costs
- Cost of items purchased for resale
- Overheads such as utilities related to production of items to be sold
- Indirect costs, including sales force and distribution
In this formula, “beginning inventory” is the value of inventory and the start of the reporting year (which is in fact calculated at the end of year before). “Cost of goods”, as you may expect, is the cost of all goods purchased or produced through the year. “Ending inventory” is defined as the value of all inventory at the end of the year.
FORMULA 2
In the second method, any change in inventory is used to adjust the Cost of Goods. Let’s look at an example:
At the start of the year, Bob’s Hardware Store places an order for 100 ladders. By the end of the year, Bob’s inventory has increased by 20 ladders. In this case, the cost of 480 ladders is the Cost of Goods Sold.
Had Bob’s inventory fallen by 30 ladders at the end of the year, then the cost of 130 ladders would be the Cost of Goods Sold.
Other Uses for COGS
When a business wants to determine its inventory turnover (the number of times they sell or replace their inventory in a given period) COGS can be used for this purpose. It is sometimes also used to determine gross margin.
Variable Inventory Cost and COGS
With so many factors involved in determining the Cost of Goods Sold, it’s no surprise that it is not a number that remains static over the course of a year. In order to accurately report COGS, these fluctuations need to be accounted for, and there are three ways to do this:
- First in, first out (FIFO). Goods which arrive or are made first, are sold first
- Last in, first out (LIFO). The most recent goods to arrive or be made are sold first
- Average cost. The average Cost of Goods Sold throughout the reporting period is calculated.
Billwaze
Jeff Liebov is the CEO & Founder of BILLWAZE. Jeff envisioned a simpler way out of the complicated world of accounting apps and created BILLWAZE. As a tool, BILLWAZE makes things easy for those who want to get things done fast, without all the hassle. Jeff and the team are continuously improving the platform and are passionate about making the entire billing process simpler than ever.
Relevant Blog
5 Ways To Improve Your Businesses Productivity
Published on April 10, 2023 by Stephanie MilneRunning a small business is not always easy. With many demands on your time, it’s easy to lose focus and try to do everything all at once, rather than to concentrate on what really matters one step at a time. Productivity can suffer as a result, affecting your business’s competitiveness and profitability; in challenging economic […]