Knowing the cost involved in purchasing or making the product is crucial to knowing how profitable the business will be for any business dealing in the sale of products. The Cost of Goods Sold (COGS) is the total cost of goods sold by the business within an accounting period. Calculating the COGS will help you know your gross profit, price products and manage inventory.
In this blog post, we'll learn how to calculate the COGS, understand the parts in the COGS formula, learn different inventory costing methods, and understand how businesses can better manage their product cost.
Understanding Cost of Goods Sold and Its Importance to Your Business
Prior to the computation, it is essential to learn what goes into COGS and its significance. It directly impacts gross profit, hence the significance of COGS accounting.
What Does the Cost of Goods Sold Mean?
Cost of Goods Sold means the cost that is directly related to producing or buying the products that the company sells. According to the nature of operations, the cost of goods sold may cover the cost of raw materials, cost of goods bought, and labor costs.
Cost of Goods Sold usually excludes indirect expenses related to business activities, like advertising and promotion expenses, office rent, administrative expenses, and general utilities.
Why Is COGS Important for Business Profitability?
COGS is an essential part of calculating the gross profit. This is illustrated by the formula: Sales revenue − COGS = Gross profit. Should the cost of producing/acquiring products rise and selling prices do not change, then the gross profit margin of the company could be reduced.
COGS measurement allows the business owner to analyze the price and inventory decisions made. If the cost of production is rising continuously, then the management can look into pricing and inventory issues.
How Does COGS Affect Taxes and Financial Reporting?
This is because COGS is a cost incurred in earning revenues. Therefore, it will influence the gross profit and income tax of the business. It is necessary to keep proper records of the inventory and classify expenses correctly while preparing the financial reports and tax records.
This depends on the form of organization and methods of inventory used in the business. Businesses need to keep consistent records and consult competent accountants in case of any doubt.
How to Calculate COGS Step by Step
Calculation of the basic cost of goods sold involves three important numbers that include the beginning inventory, the purchases, and the ending inventory. After obtaining the above numbers, the calculation process becomes easier.
Start With the Beginning Inventory
The beginning inventory refers to the value of the inventory at the start of the accounting period. For an already existing firm, this amount will be calculated from the ending inventory of the previous accounting period.
Take the case of a clothing business with an inventory of $10,000 at the start of the accounting period. This is the beginning inventory for the current accounting period.
Add Purchases Made During the Period
Now comes the determination of the cost of the inventory that was purchased within the accounting period. This could mean that inventory has been purchased for reselling purposes or material for manufacturing products could have been bought.
The costs incurred while buying the inventory, including some shipping and import charges, must also be determined. If the company purchases $5,000 worth of inventory during the year, this will be added to the $10,000 opening inventory.
Subtract the Ending Inventory
The ending inventory is the value of goods that are still left to be sold at the year-end. As they have not yet been sold, their cost will not be considered part of the COGS for the current period.
For instance, the inventory left at the year-end is worth $3,000. In this case, the formula will look as follows:
COGS = Beginning Inventory + Purchases − Ending Inventory
COGS = $10,000 + $5,000 − $3,000
COGS = $12,000
The business therefore reports $12,000 as its COGS for the period based on these figures.
Choosing an Inventory Costing Method and Managing COGS
The formula for calculating COGS is simple. However, when a company buys similar items at various prices, the cost allocated to the inventory becomes tricky. Techniques used to account for inventory provide information on the cost allocated to the cost of goods sold and ending inventory.
How Do FIFO, LIFO, and Average Cost Methods Work?
Firms can adopt different methods for valuing inventory depending on their accounting policies and regulations. The three popular valuation methods include FIFO, LIFO, and average cost method.
|
Method |
Basic Approach |
General Effect When Costs Rise |
|
FIFO |
Oldest inventory costs are assigned to goods sold first |
Often results in lower COGS and higher gross profit |
|
LIFO |
Newest inventory costs are assigned to goods sold first |
Often results in higher COGS and lower gross profit |
|
Average Cost |
Uses an average cost for inventory units |
Smooths fluctuations in unit costs |
The method used could impact the cost of goods sold, inventory, and profitability. Companies must employ the inventory method that suits their case and apply it in a consistent manner according to the relevant standards.
What Are Practical Ways to Reduce COGS?
Lowering COGS will benefit gross profit, but companies should not lower costs at the expense of product quality and customer satisfaction. Companies could instead look into identifying inefficiencies in the entire process of purchases, production, and stock management.
Companies might consider negotiating with suppliers, buying in bulk, lowering waste during production, and managing their stock levels properly. They might also try to forecast their demand better so as to not have too much stock on hand that is hard to sell.
How Can Accounting and Bookkeeping Services Help With COGS?
Proper calculation of COGS requires dependable inventory and accounting records. An accountant/bookkeeper can assist companies in recording their expenses and transactions, keeping an account of the movement of inventory, and also maintaining financial records that will help in proper accounting services.
Accountants/bookkeepers can further guide business owners on the impact of any change in COGS on gross margin or profit. By ensuring proper financial records, business owners can easily recognize any abnormal increases in expenses, make necessary pricing decisions, and also improve purchasing or inventory systems.
Cost of Goods Sold (COGS) is a crucial calculation for companies that have sales of merchandise. Using the beginning inventory, purchases, and the ending inventory, one can determine the actual cost of goods sold and use it as a basis for analyzing gross profitability.
Keeping accurate records of COGS will also help in pricing, inventory control, financial reporting, and taxation planning. Whether you handle your accounting in-house or utilize the assistance of professional accountants and bookkeepers, keeping accurate records of your inventory and purchases is very important.
The Fino Partners can help businesses maintain accurate accounting records, manage inventory-related financial information, and monitor important profitability measures such as COGS. Contact The Fino Partners today for professional accounting and bookkeeping support designed around your business’s financial needs.
