What is the Cost of Goods Sold?

Knowing about your cost of goods sold is the first thing you should do before calculating your business profit. This is an essential factor that helps in deciding the prices for you. We will make you aware of the term cost of goods and help you calculate it. Besides, you will also come to know about its significance in developing your small business.

What is the cost of goods sold?

Basically, the terminology "cost of goods sold" means the expense involved in producing your services and products. It is also popular by the term cost of sales or cost of services. COGS includes all the raw materials, equipment costs, and labor expenditures required to produce each of the goods you deal in.

Remember that when you are calculating the cost of goods sold, you should not include the expense of manufacturing those goods that have not been sold yet. Indirect expenses do not fall under COGS. For instance, you cannot include expenditures like overhead charges, marketing expenses, utilities, shipping fees, etc., in your cost of sales.

Let us help you understand with an example.

Suppose you are the owner of a cabinetry brand. Then your cost of goods sold will include items like screws, wood, paint, glass, and the labor required to manufacture the cabinets. But, the amount you have spent on marketing your cabinets, charges of shipping, and the electricity that has been consumed for operating machinery will not be included in the cost of sales.

Keep in mind that the cost of goods sold is always an integral part of the income statement of your business. In case the COGS exceeds the revenue in that specific accounting period, it will indicate that the company has made no profit in that particular year. The cost of goods sold is an extremely crucial factor for any business as it helps in analysing the management of overall purchase and payroll expenses.

Know the formula for calculating the cost of goods sold

If you wish to know what is the cost of sales for your business, you need to use the COGS formula.

Here we go,

COGS = Beginning inventory + Purchases made during the period – Ending inventory

Whatever inventory or stock is leftover from the previous session will be called the beginning inventory for you. After that, you need to add the expenses of whatever purchases you have made during the ongoing period. Lastly, you need to subtract the cost of inventory which you could not sell till the end of the period. The period about which we are talking here varies significantly according to different business enterprises.

Case study for understanding COGS better

ABC company considers the calendar year to calculate its cost of goods sold. They recorded the beginning inventory and ending inventory on 1st January 2020 and 31st December 2020, respectively.

The beginning inventory amounted to $9,000, while the ending inventory valued about $2,000. In the meanwhile, throughout the accounting period, purchases were made worth $5000.

By using the cost of sales formula, ABC company calculated the cost of goods sold for the year.

COGS = 6,53,679.00 INR +3,63,155.00 INR - 1,45,262.00 INR

COGS = 8,71,572.00 INR

Thus, they derived the COGS to be 8,71,572.00 INR.

Now that the company knows well about its COGS, it can make better business decisions. For future business operations, the company will search for better vendors and more profitable deals.

How to calculate COGS using different methods?

COGS of any company rely on the inventory costing methodology of the company. There are three different methods that a company can put to use. These are:

• LIFO (Last In, First Out): In this case, the latest goods which get added to the inventory are sold first. At times when the prices are rising, the goods with higher prices get sold first. This eventually leads to a higher cost of goods sold. With time, the net income gradually decreases.
• FIFO (First In, First Out): In this case, the goods which were purchased earlier are sold first. Thus, a company will be able to sell the least expensive products first, as the prices generally go up with time. This leads to lower COGS. Thus, the net income tends to increase in this method.
• Average cost method: To avoid severe alterations in the value of COGS, business enterprises generally prefer to use this methodology. This method involves using the average cost of all the manufactured or purchased inventory, irrespective of the production or purchase date. Thus, extreme or inaccurate values do not come during the calculation, and calculating the cost of goods sold gets easier. Determining taxes and profitability also becomes hassle-free and convenient.

Why is it significant to calculate your COGS?

• Enhanced understanding of the financial health of your business: When you start calculating your cost of sales, you will become aware of the overall financial health of your business. This level of understanding will help make significant decisions like whether or not there is a requirement to improve your inventory management or if there is a need to make a higher level of investment in any specific area of your business.
• Effective management of your taxes: COGS is purely a business expense. Thus, it is absolutely tax-deductible. Thereby, you can manage your taxes effectively and also avoid any kind of legal issues. In case the cost of sales is high, the net income will be below. So, you will not have to pay high taxes. Paying a low amount of taxes can save your business capital, but it also indicates that you are making fewer profits. You can find a healthy balance to make sure that your business is operating efficiently and is also making high profits.
• Apt price for your products: Knowing your cost of goods sold can help set the apt prices for your products. When the price is right, you will be able to cover all your expenses and make a healthy profit. The knowledge of COGS helps you to decrease or increase the prices of your products suitably.
• Foreseeing future opportunities for business proliferation: When you notice historical alterations in your COGS, you will be able to identify seasonal trends in the expenditure of your raw materials. Go through the cost of goods sold over the last few years, and this will give you the figures of historical alterations in your COGS. For instance, you can deduce that your cost of sales has been higher during winter. This basic information will prove to be of great value and significance to your business operations.

Conclusion

Calculating and managing the cost of goods sold is of utmost significance for small businesses. When you keep an eye on your cost of sales, you will be able to identify which areas of business production are consuming more money. Also, COGS details will help you locate the area which still has room for improvement. In case you discover that your cost of goods sold is higher even when things are running smoothly and efficiently, then there is a dire need to re-think the product you are dealing in. After all, it will not be an intelligent decision to overstock a commodity that is not-so-popular. Also, you should not sell the most-coveted products at a price that is lower than its production expense.

Hence, keep track of your COGS and run your business smartly.

Also Read:

1) How Do Business Taxes Differ From Personal Taxes?
2) Why Do We Pay Income Tax in India? Importance, Applicability & more
3) Provisions for Income Taxes in India Applicable for Salaried People.
4) OkCredit: All you need to know about OkCredit & how it works.

FAQs

Q. Which business enterprises are excluded from COGS?

Ans. As per the norms of GAAP or Generally Accepted Accounting Principles, COGS is the expenses for the inventory that has been sold during a specific time period. However, multiple companies do not have any inventories at all. These are:

1. Business consultants
2. Accounting firms
3. Business consultants
4. SaaS businesses

As they do not have any COGS, they do not enlist any cost of goods sold in their income statement. However, such companies do have other expenditures, such as utilities, rent, office supplies, to name a few.

Q. What's included in the Cost of Goods Sold?

Ans. Here's what included in the COGS:

• Cost of things expected for resale
• Cost of crude materials
• Cost of parts used to make an item
• Direct work costs
• Supplies utilised in one or the other making or selling the item
• Overhead expenses, similar to utilities for the assembling site
• Transportation or cargo costs
• Roundabout expenses, similar to appropriation or deals power costs
• Compartment costs

Q. Can COGS help me to understand the debt-related issues?

Ans. COGS also helps you to determine if you are in a position to pay back your debts or not, if you should reduce the payroll expenditures or if there is a severe need to shut down your business altogether.