What Is Cost of Goods Sold – COGS?
Cost of goods sold (COGS) refers to the direct costs of producing the goods sold by a company. This amount includes the cost of the materials and labor directly used to create the good. It excludes indirect expenses, such as distribution costs and sales force costs.
COGS = Beginning Inventory + Purchases During the Period – Ending Inventory
Before you start calculating your business’s profit, you need to know your cost of goods sold. And, knowing what the cost of goods sold is plays an important role in setting prices. But what is the cost of goods sold?
Understand what the cost of goods is, how to calculate it, and why it’s important for your small business.
The cost of goods sold (COGS), also referred to as the cost of sales or cost of services, is how much it costs to produce your products or services. COGS include direct material and direct labor expenses that go into the production of each good or service that is sold.
When calculating the cost of goods sold, do not include the cost of creating goods or services that you don’t sell.
COGS does not include indirect expenses, like certain overhead costs. Do not factor things like utilities, marketing expenses, or shipping fees into the cost of goods sold.
If you own a cabinetry company, examples of COGS would include the wood, screws, hinges, glass, paint, and labor used to make the cabinets you sell. However, the costs to market the cabinets, the electricity needed to operate the machinery, and shipping are not included in the COGS.
To find the COGS on a product, add up the cost of raw materials and direct labor needed to create it.
To find the cost of goods sold during an accounting period, use the COGS formula:
COGS = Beginning Inventory + Purchases During the Period – Ending Inventory
Your beginning inventory is whatever inventory is left over from the previous period. Then, add the cost of what you purchased during the period. Subtract whatever inventory you did not sell at the end of the period.
Accounting periods might be months, quarters, or calendar years.
More on the Cost of Goods Sold
Cost of goods sold is the accumulated total of all costs used to create a product or service, which has been sold. These costs fall into the general sub-categories of direct labor, materials, and overhead. In a service business, the cost of goods sold is considered to be the labor, payroll taxes, and benefits of those people who generate billable hours (though the term may be changed to "cost of services"). In a retail or wholesale business, the cost of goods sold is likely to be merchandise that was bought from a manufacturer.
In the income statement presentation, the cost of goods sold is subtracted from net sales to arrive at the gross margin of a business.
In a periodic inventory system, the cost of goods sold is calculated as beginning inventory + purchases - ending inventory. The assumption is that the result, which represents costs no longer located in the warehouse, must be related to goods that were sold. Actually, this cost derivation also includes inventory that was scrapped, or declared obsolete and removed from stock, or inventory that was stolen. Thus, the calculation tends to assign too many expenses to goods that were sold, and which were actually costs that relate more to the current period.
In a perpetual inventory system the cost of goods sold is continually compiled over time as goods are sold to customers. This approach involves the recordation of a large number of separate transactions, such as for sales, scrap, obsolescence, and so forth. If cycle counting is used to maintain high levels of record accuracy, this approach tends to yield a higher degree of accuracy than a cost of goods sold calculation under the periodic inventory system.
The cost of goods sold can also be impacted by the type of costing methodology used to derive the cost of ending inventory. Consider the impact of the following two inventory costing methods:
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First in, first out method. Under this method, known as FIFO, the first unit added to inventory is assumed to be the first one used. Thus, in an inflationary environment where prices are increasing, this tends to result in lower-cost goods being charged to the cost of goods sold.
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Last in, first out method. Under this method, known as LIFO, the last unit added to inventory is assumed to be the first one used. Thus, in an inflationary environment where prices are increasing, this tends to result in higher-cost goods being charged to the cost of goods sold.
For example, a company has $10,000 of inventory on hand at the beginning of the month, expends $25,000 on various inventory items during the month, and has $8,000 of inventory on hand at the end of the month. What was its cost of goods sold during the month? The answer is:
$10,000 Beginning inventory + $25,000 Purchases - $8,000 Ending inventory
= $27,000 Cost of goods sold
The cost of goods sold can be fraudulently altered in order to change reported profit levels, such as by engaging in the following activities:
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Altering the bill of materials and/or labor routing records in a standard costing system
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Incorrectly counting the quantity of inventory on hand
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Performing an incorrect period-end cutoff
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Allocating more overhead than actually exists to inventory