Accounting

What Is Cost of Goods Sold (COGS) in Accounting?

Nov 24, 2021 Brett Hughes

Have you ever laid in bed at night and had trouble falling asleep because you didn’t know the answer to “What is the cost of goods sold?” 

Oh, so that’s never happened to you? 

Even if you’ve never lost sleep from COGS, all business owners should have an understanding of what it is and, more importantly, why it’s important.

The short answer is that COGS are your production costs, and it’s important because it helps determine your company’s profits. 

And I’d argue that COGS is more about inventory than sales. I know you’re thinking, “How does what I don’t sell (inventory) change the value of what I do sell (COGS)?” But stick around, and we’ll get into more detail about both of these so you can rest easier tonight.

What Is Included and Excluded in the Cost of Goods Sold?

As the name suggests, COGS are the:

  • Cost
  • Of the
  • Goods that you
  • Sold

This includes the variable direct costs (both the direct labor and the raw materials) and fixed costs like factory overhead. 

An easy way to think about COGS is to ask yourself, “Would I incur these costs if I didn’t make a product?” If the answer is no, then these expenses are included in your COGS calculations.

Some of the standard inputs for COGS are:

  • Raw materials
  • Freight costs to receive raw materials
  • Items purchased for resale
  • Direct labor costs (e.g., factory workers’ wages and payroll taxes)
  • Parts used in production (e.g., screws, glue, paint)
  • Storage costs 
  • Factory overhead (e.g., utilities, maintenance)

But some ordinary business expenses excluded from the COGS calculation are:

  • Selling and marketing costs
  • Shipping costs to get a product to the customer
  • Accounting and legal fees
  • Indirect labor costs (e.g., management and administrative salaries, cost of labor, etc.)
  • Interest
  • Ending stock you still have on hand. This sits on the balance sheet as inventory.

How Do I Calculate Cost of Goods Sold?

Now that you know some of the costs included in COGS, you’re probably wondering, “So how do I calculate this number?”

Rest assured, I’ve got you covered.

The basic COGS formula is:

Beginning Inventory + Purchase – Ending Inventory = COGS

So what does that mean? Let’s dig just a little deeper.

COGS & Inventory

Calculating the cost of goods sold rests mainly on the cost of inventory. So how you value stock has a significant impact on your COGS and resulting gross profit. 

Accounting principles/rules (i.e., GAAP) allow a few different methods for calculating inventory costs that we’ll discuss.

First-In, First-Out (FIFO)

FIFO shouldn’t be confused with Fido. Leave the family pup out of this discussion.

The FIFO valuation method assumes that the oldest inventory (the first in) is sold first (the first out the door). That means that the stock remaining on your shelves at the end of the accounting period is the newest. 

In general, FIFO will result in a lower COGS amount and a higher ending inventory value. That’s based on the assumption that newer raw materials and labor have higher costs than older ones.

Last-in-First-Out (LIFO)

The opposite of FIFO is LIFO. It assumes that the newest items produced (the last ones in) are the first ones sold (the first out) when a customer makes a purchase.

That means that the oldest products are the ones left in your warehouse when it’s financial reporting time. 

Using LIFO will usually result in higher COGS values and lower ending inventory amounts.

Average Cost Method

The average cost method blends the production costs throughout the reporting period. This evens out costs and prevents price fluctuations. 

You’ll add up the total costs to produce your goods and divide it by the number of units created in the period. 

If it costs you $100,000 to produce 50,000 widgets, your average cost is $2 per widget.

Cost of Goods Sold Examples

We’ve talked a lot about calculating the cost of goods and the accounting methods you can use to value inventory. But let’s look at an example using numbers in case words aren’t your strong suit.

Assume, PlanningPapers, LLC designs and sells planners and organizers. On January 1, the value of their inventory was $20,000. With partnerships with a few vendors, they purchased an additional $50,000 worth of planners during the month. At the end of January, their ending inventory was valued at $31,000. 

Using our cost of goods sold formula, we have:

Beginning inventory$20,000
Purchases$50,000
Ending inventory$31,000
Cost of goods sold$39,000

How Is COGS Different From Cost of Revenue and Operating Expenses? 

It might seem logical to think of the cost of goods sold as the cost of revenue (or cost of sales). After all, generating your revenue costs you something. 

But COGS and cost of revenue aren’t the same. There are subtle differences.

COGS vs. Cost of Revenue

Cost of revenue is a broader metric because it includes some indirect costs that aren’t included in a COGS calculation. 

Cost of revenue will generally include the cost of the direct selling and marketing expenses, including things like sales commissions, advertising, and distribution expenses.

But like COGS, it will exclude administrative costs like manager salaries and insurance premiums that aren’t directly attributable to a sale.

COGS vs. Operating Expenses

You can generally think of operating expenses as the anti-COGS. They are those amounts that you think of when you think of overhead costs. They can also be referred to as “general and administrative expenses” on the income statement.

Examples of operating expenses are:

  • Depreciation
  • Manager and administrative salaries
  • Office supplies
  • Telephone expenses
  • Travel costs
  • Interest
  • Bank fees

And operating expenses have nothing to do with COGS. So forget about them for now.

What Does the Cost of Goods Sold Tell You, and Why Is It Important?

Cost of goods sold is needed to calculate your gross profit. Because:

Gross Sales – COGS = Gross Profit

And knowing this information tells you if your small business is viable. Knowing your COGS lets you set customer pricing correctly to ensure adequate profit margins.  And these gross profits are used to pay for your operating expenses.

If your gross profit is too low, you won’t have enough money left over to cover your operating expenses. 

It might help to see what a basic income statement looks like to illustrate the importance of COGS and gross profit. 

Source: Accountingcoach.com

Other ways that COGS is helpful and important for your company include:

  • Calculating inventory turnover to see how quickly you replace inventory
    • Can help optimize inventory levels and prevent inventory obsolescence
    • Can help decide on sales and promotion strategies to move product
  • Calculating gross profit margins to maximize pricing and control costs

COGS and Taxes

We’ve focused on COGS as it relates to calculating and preparing your company’s financial statements. But you probably wouldn’t be all that surprised to learn that the IRS is also interested in your COGS numbers.

For tax purposes, businesses that hold physical inventory need to show their COGS values to calculate their taxable net income. 

The technical details of reporting COGS on tax returns are beyond the scope of this article, and it would put you to sleep in five minutes if we did go into the details. But if you want to learn more, you can check out some of the IRS’s resources. 

Congratulations, if you’ve made it this far, we haven’t bored you so much to cure your insomnia or make you run for the hills.

Although COGS is a relatively dry and dull topic, it’s vital for businesses. Not only does it help make pricing decisions, but it also impacts your net income. Whether you’re looking to maximize your bottom line for yourself or are eyeing selling your business in the future, COGS plays an essential role in beefing up your corporate value.