Introduction
If you’re running a business – or plan to in the future – understanding cost of goods sold is essential. Cost of goods sold (COGS) is the direct cost associated with producing and selling a product. It’s an important factor in determining a company’s profitability. In this article, we’ll explore what COGS is, how to calculate it, and why it’s important to track and analyze.
Defining cost of goods sold and its calculation
COGS includes all the costs associated with producing a good or service that has been sold. It does not include other expenses unrelated to production like marketing, rent or utilities. COGS can be calculated with a straightforward formula:
COGS = Beginning Inventory + Additional Inventory – Ending Inventory
The result of this calculation is the cost of the inventory that has been sold during a set period of time – typically a year. The COGS is then subtracted from the revenue generated by the sale of goods or services to determine gross profit. Understanding COGS is crucial for business owners to determine the financial health of their business and profitability.
Identifying types of costs that make up cost of goods sold
The costs that make up COGS can be divided into two categories: direct costs and indirect costs. Direct costs are those that are directly attributable to producing a good or service. These costs can include raw materials and labor to produce the product. Indirect costs are overhead expenses that cannot be directly traced to the production of a good or service. These costs can include rent, utilities, and salaries of non-production employees.
Examples of costs that make up COGS include:
- Raw materials and supplies
- Direct labor costs for production of goods or services
- Cost of packaging and shipping materials
- Manufacturing overhead (like utilities or maintenance)
- Direct production labor costs like wages or salaries for people who work on or help produce the product
- The cost of goods purchased for resale
Discussing the importance of tracking and monitoring cost of goods sold
Understanding COGS and tracking it over time is crucial for businesses in determining their profits and margins. COGS is key to pricing strategies and inventory management, which can both be make or break factors for businesses success. COGS can impact decisions about pricing, staffing, supply and demand, and capacity. Analyzing COGS can also help businesses identify inefficiencies, make adjustments, and ultimately increase profitability.
Describing the different methods for calculating cost of goods sold
There are three main methods used to calculate COGS: First-In, First-Out (FIFO), Last-In, First-Out (LIFO), and Weighted Average. The method used can affect the amount of COGS calculated and must be used consistently throughout the accounting process.
FIFO assumes that the first items purchased are the first items sold. This method results in the most current inventory being left on the shelves, which can cause prices to increase. LIFO, on the other hand, assumes that the latest items purchased are the first items sold. This method can result in an increase in the cost of goods sold, lowering the business’ taxable income. Finally, the Weighted Average method averages the cost of all goods in the inventory and applies that average cost to each unit sold.
The advantages and disadvantages of each method should be carefully considered before deciding which one to use.
Providing step-by-step instructions for calculating cost of goods sold
If you’re calculating COGS manually, the following is a brief overview of how to do so. You’ll need to refer to your business’ accounting records like purchase invoices, materials used, and inventory levels during the reporting period.
FIFO
- Determine the cost of goods available for sale during the period.
- Identify the cost of the oldest inventory held beginning the reporting period.
- Record the units and cost of these goods.
- Identify the cost of units purchased during the period.
- Multiply the number of units sold by their cost per unit. Deduct the merchandise cost from the sales revenue to calculate gross profit.
LIFO
- Determine the cost of goods available for sale during the period.
- Identify the cost of the newest inventory held beginning the reporting period.
- Record the units and cost of these goods.
- Identify the cost of units purchased during the period.
- Multiply the number of units sold by their cost per unit. Deduct the merchandise cost from the sales revenue to calculate gross profit.
Weighted Average
- Determine your total cost for goods available for sale during the period.
- Determine the total number of units available for sale.
- Calculate the weighted average cost per unit available for sale.
- Multiply the number of units sold by the weighted average cost per unit.
- Deduct the merchandise cost from the sales revenue to calculate gross profit.
Highlighting software tools and programs that can help with calculating cost of goods sold
While it’s possible to calculate COGS manually, many businesses find it easier and more accurate to use software tools and programs that are specifically designed for the task. These software programs can make it easy to track inventory and the cost associated with production. They can help businesses understand their margins and make informed decisions about pricing and product development.
Examples of software tools and programs available for calculating COGS include:
- Zoho Inventory
- TradeGecko
- Xero
- QuickBooks
When choosing software or tools, it is important to consider how it integrates with other existing business tools, the features offered, and the company’s size and budget. Often, it can be helpful to try multiple tools out before choosing the best one to suit your business’ needs.
Conclusion
Calculating COGS is fundamental for businesses to assess their financial health and profitability. COGS is used in pricing strategies, inventory management, and financial reporting for businesses of all sizes. Learning how to calculate COGS is good practice for business owners because it will enable them to make informed decisions and stay profitable. By following the guidelines outlined in this article, and utilizing the appropriate software tools, businesses can grow and thrive.