What is COGS?
Also called cost of sales or cost of services, the cost of goods sold is how much it costs to produce your products or services. This includes raw material and labour costs directly connected to the production of each good or service that is produced and sold. It doesn’t include indirect costs such as business overhead costs, rent, utilities, marketing costs and shipping expenses.
For example, if your business manufactures furniture, you would include expenses such as wood, glue, paint, hardware and labour in the cost of goods sold. You wouldn’t include the utilities used to run your machinery and equipment. Other overheads such as administration, rent and advertising would not be included in COGS.
For finished goods that are resold, the cost of inventory can include freight costs but would not include overheads such as storage.
How to calculate cost of goods sold
The cost of goods sold formula (also known as the COGs formula) is used to determine the COGS during a specified accounting period:
COGS = Beginning inventory + Purchases during the period – Ending inventory
Beginning inventory is the value of the inventory left over from the previous period. You add the cost of what has been purchased during that period. Then you subtract the value of inventory that did not sell by the end of the period.
The COGS formula can be applied to the accounting period you are analysing, such as a month, quarter or financial year.
Example of calculating COGS
If a business uses a July to June financial year for recording inventory, you would record the value of the beginning inventory on 1 July and the ending inventory on 30 June.
Let’s say your beginning inventory is $45,000, purchases inventory worth $25,000 and has an ending inventory of $10,000. Using the cost of goods sold formula:
COGS = $45,000 + $25,000 – $10,000 = $60,000
Knowing your cost of goods sold for the financial year will help you make decisions concerning your labour costs, selecting suppliers for raw materials, finished goods and the prices you charge.
Cost of goods sold and your financial statements
Once you have calculated COGS you can determine your gross profit and net profit as found on the income statement (also known as a profit and loss statement), which includes sales, revenue, COGS, gross profit, operating expenses and net profit. Here’s an example of a section from a profit and loss statement:
Sales revenue $550,000
Less: COGS $300,000
Gross profit $250,000
Less: Operating expenses $125,000
Net profit (net income) $125,000
Operating expenses are the business expenses that are not directly related to the cost of goods sold. These include general costs incurred in running the business, including overheads, administration, marketing and other expenses.
For a more detailed example and explanation of how to calculate your net and gross profit margin, check out Gross Profit vs Net Profit: What’s the Difference?
COGS and inventory costing methods
The cost of acquiring inventory can change over time, so your COGS will depend on which of the following inventory costing methods you use:
- FIFO (first in, first out)
- LIFO (last in, first out)
- Average.
When determining the cost of inventory with FIFO, items that come in first are considered to go out first. With LIFO, items that come in last are considered to go out first when sold. With the average inventory method, you use the average cost of items over time to calculate the value of the inventory and cost of goods sold. For a more detailed look at inventory, check out Inventory Management: A Short Guide for SMEs.
Cost of services
The idea of cost of services is similar to cost of goods sold but applies to businesses that sell services, such as accounting, legal, consulting and training. The cost of services include those costs that go directly into delivering these services. So, in general, this would be wages, salaries and freelance fees paid to professionals delivering these services to the firms clients. For an accounting firm, for example, the wages of administration staff not involved in delivering services to clients are not included in cost of services. The same applies to overheads and other expenses that are not connected to the delivery of accounting services.
Business finance solutions to bridge the gap between acquiring and selling goods
The gap between creating or purchasing goods and selling them creates cash flow challenges for small businesses. Unsecured business loans are one way to bridge this gap. To get and estimate of interest and principal repayments, check out our business loan calculator.
