As a business owner, you are constantly looking for methods to cut costs and increase profits. Carefully monitoring your Cost of Goods sold (COGS) is one approach to achieve this. Knowing your COGS gives you a clear picture of your company's costs. And further facilitates the decision-making process when it comes to pricing, inventory, and expenditures. Because a high Cost of Goods sold can cut into a company's profitability, it's critical to monitor this figure and understand what it means for your organisation.
Some of you may be wondering what we mean when we talk about "Cost of Goods Sold" and how it helps your company. We've written this post to help small and medium-sized business owners (SMEs) understand what this phrase means. Let's begin with it.
What Is the Cost of Goods Sold?
In terms of accounting, Cost of Goods Sold (COGS) refers to the direct costs associated with the production of the goods sold by a company.
As per this definition of cost of goods sold, it includes the cost of the materials used in production, the cost of the labour used to produce the goods, and the cost of any other direct expenses item which is associated with the production of the goods. COGS does not include indirect expenses, such as marketing or administrative costs.
The calculation of COGS is essential for two main reasons. First, it is used to determine the gross profit amount of a company, which is the difference between the revenue generated from the sale of goods and the cost of producing those goods. Gross profit is a significant metric for assessing the financial health of a company. Second, the COGS calculation is used in the determination of tax liability. The cost of goods sold is deducted from a company's revenue in order to calculate taxable income.
Additionally, the creditors and investors who are the company's stakeholders may find these two data of COGS and Gross Profit, to be very helpful in determining the percentage of revenues that can be used by the business to pay for its operating expenses.
What is the Cost of Goods Sold Formula?
The cost of goods sold or COGS is determined using the following formula:
COGS = Inventory at the Beginning of the year + Net Purchases - Closing Inventory at the end of the year.
The value of inventory at the beginning of the year is really the end of the previous year as stated in the balance sheet from the prior year. The total cost of any purchases, less any Purchase Returns, is known as Net Purchases. Additionally, all raw materials, components, and goods bought from other parties within the reporting period are included in the purchases completed during that period. The value of the raw materials and finished items in stock at the end of the year is referred to as the Closing inventory for that reporting year.
Example for Calculating the Cost of Goods Sold
Let's take an example to explain better the formula of the Cost of Goods sold mentioned above.
ABC Ltd. is a company in the printing and packaging industry. According to the year 2019-2020, the company has ₹10,00,000 of inventory on hand at the end of the year. Further, in the year 2020-2021, it spends ₹25,00,000 on various raw materials, components and inventory items during the year. Additionally, it is mentioned in the 2020-2021's balance sheet of ABC Ltd. that it has ₹8,00,000 of inventory on hand at the end of the year. What was its cost of goods sold during the year 2020-2021?
So at first, by analyzing the formula and this question, we must identify our key components.
That is,
Inventory at the beginning of the year 2020-2021 = ₹10,00,000. Net Purchases of the year 2020-2021 = ₹25,00,000. Closing Inventory of the year 2020-2021 = ₹8,00,000.
So, as per the formula -
Cost of Goods Sold for the year 2020-2021 = ₹10,00,000 + ₹25,00,000 - ₹8,00,000.
COGS for the year 2020-2021 = ₹27,00,000.
How to Calculate Cost of Goods Sold Using Different Methods?
Depending on the inventory costing method a company uses, the cost of the goods sold will be valued. However, there are a few important things to keep in mind. First, it is important to properly account for any discounts or allowances that are given on the sale of goods. Second, it is important to properly account for the cost of any inventory that is sold but not yet produced (such as work-in-progress inventory). Finally, it is important to properly account for any freight or shipping costs that are incurred in the sale of goods.
There are three primary methods for calculating the cost of goods sold, and one more complex one to be used for unique and specific items. Let's discuss them all in detail.
FIFO
The first-in, first-out or FIFO method assumes that the goods that are sold first were also the first goods produced. In an inflationary setting, where the FIFO method is very suitable from the rest, the cheapest or oldest inventory goods are charged to be sold first, which further increases the reported profit level as COGS for these goods will be less. Additionally, it also implies that the ending inventory level has reached its peak. This method usually shows actual usage trends.
LIFO
The last-in, first-out or LIFO method assumes that the goods that are sold first were the last goods produced. In an inflationary setting, where the LIFO method is not very suitable from the rest, the latest inventory goods are charged to be sold first, which decreases the reported profit level as COGS for these goods will be much higher as compared to goods produced at first. Further, the net income of the organization following the LIFO method tends to decrease.
Average Cost Method
The weighted average method takes into account the cost of goods sold over a period of time, rather than assuming that the goods sold first were also the first produced. By dividing the price of the goods by the number of units for sale, the weighted average cost method calculates costs. This is a decent strategy that tends to produce outcomes that fall somewhere between the FIFO and LIFO strategies.
Special Identification Method
The special identification method determines the ending inventory and COGS for each period based on the precise cost of each unit of product. In this way, a company knows exactly which item was sold and at what price. If a business (for example, a jewellery shop, an art gallery or a car dealership) can specifically identify particular items of inventory, it can employ the specific identification approach.
What is the Difference Between the Cost of Sales and the Cost of Goods Sold?
The main difference point between the Cost of Goods sold and the Cost of sales is that the COGS only takes into account all direct and overhead production costs for the goods sold in any year. But in the Cost of sales, all the costs that come under COGS plus the indirect costs incurred to make those final sales are taken into account. So when we talk about indirect expenses includes selling and advertising expenses and many other similar expenses. Businesses need to take both Cost of Goods Sold and the Cost of Sales into account whenever they are trying to take any decision.
Conclusion
At last, we hope with this blog we were able to solve your problem of understanding what does Cost of Goods Sold term means and why is it important for your business. Further, to advise you on one front if you are a small business and managing all your business-related activities manually. Then you might not be able to calculate the COGS as easily as you might think. Also, there is a great possibility that there is a chance of Human-error involved.
So to remove all these chances of error, you can opt for managing all your business operations digitally. And for that TranZact can be a solution you can go for. It is an inventory management tool which can help you in automating all your business processes and removing any possibility of manual error. Further, with its customized reporting and analytics options, you can easily calculate different data like the Cost of Goods sold for a particular product very easily.
FAQs on Cost of Goods Sold
1. What is included in the cost of goods sold?
Ans. The cost of goods sold includes the cost of the materials used in production, the cost of the labour used to produce the goods, and the cost of any other direct expenses items which is associated with the production of the goods.
2. What expenses are not included in the cost of goods sold?
Ans. The indirect expenses not related to the production of goods sold is not included in the Cost of Goods sold data.
3. Do you pay taxes on COGS?
Ans. The cost of goods sold is a tax deductible expense and also it includes in the price of material costs and other tax applicable. To answer this question no we don't pay taxes on COGS directly.
