Cost of Goods Sold (COGS)

The goods sold during a certain time frame and include everything a business pays to produce the goods sold in a specific period.

The cost of goods sold (COGS) is an expense account listed in the income statement of merchandising companies. It includes everything a business pays to produce the goods sold in a specific period.

These can also be referred to as the cost of sales (COS), especially for merchandising companies. Therefore, COGS, cost of sales, and COS can be used interchangeably.

It involves all the direct costs the business incurs to produce the goods it sells. These costs include the raw materials and labor used in the production process. It can also include other specific overhead costs.

Other costs not explicitly related to production, like advertising costs and other SG&A expenses, are not included in COGS.

In accounting, the cost of sales is subtracted from sales revenue to find the company's gross profit. Subtracting operating expenses (such as wages, advertising, and insurance expenses) and other expenses from gross profit will yield the company's net income.

For example, a company has $100,000 in sales revenue this year. This figure reflects the price at which the merchandise or inventory was sold during this period. If the company has COS equal to $30,000, it has a gross profit, also known as gross margin, equivalent to $70,000.

The cost of sales is always an essential indicator of any business because it affects taxable income. The higher the COS, the less taxable income. Although paying fewer taxes on income seems attractive, having a lower net income doesn't encourage the company's investors.

Every business needs to carefully calculate its sales cost to know precisely how much it costs to sell the goods they produce. This will also provide insight into the price the company should charge for its product:

●    A price equal to it will make the company break even,
●    A higher price will cover the other costs not directly related to the production of the goods sold. Eventually, the higher price will also generate profit,
●    A lower price will not cover the costs associated with producing the goods.

Understanding the cost of goods sold

Both merchandising and manufacturing companies have to calculate it. Merchandising companies buy their merchandise, also known as inventory, from manufacturers. Manufacturing companies, on the other hand, produce their products. 

Although the operating cycle is more complicated for manufacturing companies (because they are responsible for producing their products as opposed to merchandising companies), both types of companies subtract the cost of sales from sales revenue to get gross profit.

The income statement flow for both types of companies is roughly similar. The first listed item at the top of the income statement is sales revenue. It is important to note that the company's payment isn't dependent on the cost of the goods sold.  

COGS is removed from sales revenue to obtain gross profit. It is a high cost of doing business because

  1. Inventories must be purchased before selling them to consumers, incurring a cost to the business.
  2. Manufacturers need raw materials and labor, among other factors, to produce their goods.

COS is just like any other expense, but it must be shown separately in the income statement. That is due to its importance in establishing how the sales are – or can be – profitable. 

Although gross profit is a helpful metric for assessing the profitability of sales in a company, it does not accurately reflect the profitability of the corporation as a whole.

Gross profit still includes other expenses not included in the cost of goods sold. These are often referred to as operating expenses, and they have the following:

  1. Depreciation expense
  2. Wages expense
  3. Office supplies expense
  4. Utility expense
  5. Insurance expense
  6. Advertising expenses

Once these expenses are removed from gross profit, this will yield the company's income before taxes. After deducting the income tax expenses, we will finally have the company's net income. 

Formula

The inventory that a merchandising company buys is recorded in the balance sheet as an asset. It can be recorded in an "inventory" or "purchases" account or any other account specific to that product. 

The amount of inventory will be different at the end of an accounting period compared to the beginning of an accounting period due to two reasons:

  • Some of the inventory will be sold throughout the time period,
  • New inventory will be purchased during the same time period.

Therefore, calculating it requires two steps:

  1. Add new purchases to the beginning inventory balance,
  2. Subtract the ending inventory balance from the result to obtain the cost of goods sold.

The formula is as follows:

COGS = Beginning Inventory + Purchases – Ending Inventory

  • Beginning inventory is the balance of the inventory account on the balance sheet at the beginning of the year,
  • Ending inventory is the balance of the inventory account on the balance sheet at the end of the year,
  • Purchases are the new inventory that is bought during the year.

Note that the beginning balance of the current year's inventory will always be equal to the ending balance of the previous year's inventory.

New purchases are added to the beginning inventory. This new figure is called the cost of goods available for sale (beginning inventory plus purchases).

Finally, unsold merchandise is subtracted from the cost of goods available for sale to derive COS. The final number will shed light on the costs directly related to acquiring the merchandise sold during an accounting period.

In addition, there is another – more detailed – formula for calculating.

COGS = Beginning Inventory + Purchases + Freight in – Ending Inventory – Purchase Discounts – Purchase Returns & Allowances.

In addition to the traditional components of the formula :

  • Freight In is the cost incurred by the company for shipping or bringing the product from the supplier to the receiving company.
  • Purchase discounts are discounts the merchandising company receives from its suppliers if it promptly makes the full payment.
  • Purchase returns are the fees incurred when products are sent back to suppliers, while purchase allowances are discounts on the buyer's cost of previously bought goods.

Examples

Calculating it can be tedious for many businesses. That is because it can sometimes be challenging to differentiate between the direct costs that go into the production or the purchase of merchandise and the indirect costs, such as several overhead costs.

The indirect costs mentioned above are not included in the calculation. Instead, the costs include depreciation, rent paid on facilities, wages, and advertising expenses.

Inventory is also an essential component in this calculation. Therefore, the company should carefully determine its inventory at the beginning and end of its account year to get an accurate estimate of its COS.

1. Example #1 (using the simple formula)

Suppose a merchandising company's accounting year spans from January 1st to December 31st. This merchandising company would like to calculate its cost of sale for the accounting year 2021 (beginning on January 1st, 2021, and ending on December 31st, 2021).

On December 31st, 2020, the company had an inventory balance of $100,000. At the end of 2021 (December 31st, 2021), the company had an inventory balance of $120,000. Throughout the year, the business purchased $50,000 worth of merchandise.

Calculating it requires using the formula: 

COGS = Beginning Inventory + Purchases - Ending Inventory

Where:

  • The beginning inventory for 2021 is the same as the ending inventory balance of the company for 2020. Therefore, beginning inventory = $100,000,
  • Purchases = $50,000,
  • Ending inventory = $120,000.

Hence, COGS = $100,000 + $50,000 - $120,000 = $30,000.

2. Second Example (using the simple formula)

Suppose the same company with the same wants to calculate its cost of sales for 2021. The company specializes in selling t-shirts as its merchandise. The total cost dedicated explicitly to producing one shirt amounts to $3.

On January 1st, the company had 20,000 t-shirts in its warehouse. On December 31st, the business had 24,000 t-shirts in its inventory. Throughout 2021, the company bought 7,500 shirts for $3 each.

Calculating it requires using the formula: 

COGS = Beginning Inventory + Purchases – Ending inventory,

To calculate the cost of sales, we first need to calculate the beginning inventory and ending inventory balances.

  • Beginning inventory = 20,000 * $3 = $60,000,
  • Purchases = 7,500 * $3 = $22,500,
  • Ending inventory = 24,000 * $3 = $72,000.

Hence COGS = $60,000 + $22,500 – $72,000 = $10,500.

3. Third example (using the extended formula)

Say the same shirt-selling company wanted to calculate its COGS for the accounting year 2021. The total cost dedicated explicitly to producing one t-shirt amounts to $3.

On January 1st, the company had 20,000 shirts in its warehouse. On December 31st, the business had 24,000 shirts in its inventory. Throughout 2021, the company bought 7,500 t-shirts for $3 each.

In addition, the freight for the purchases was $0.50 per t-shirt. Therefore, the assets' discount amounted to $800, and the company returned $1,800 worth of t-shirts.

Calculating the cost of goods sold requires using the extended formula: 

COGS = Beginning Inventory + Purchases + Freight in – Ending Inventory – Purchase Discounts – Purchase Returns & Allowances,

Where:

  • Beginning inventory = 20,000 * $3 = $60,000,
  • Purchases = 7,500 * $3 = $22,500,
  • Freight in = 7,500 * $0.50 = $3,750,
  • Ending inventory = 24,000 * $3 = $72,000,
  • Purchase discounts = $800,
  • Purchase returns and allowances = $1,800.

Hence, COGS = $60,000 + $22,500 + $3,750 – $72,000 – $800 – $1,800 = $11,650

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Why is it important?

The cost of goods sold is an important metric that reflects a business's margins. A company that has priced its products below its COS will have negative margins and record net losses in its income statement. Therefore, this figure will always help the company to know or estimate its gross profit margins. 

If the merchandise is priced precisely equal to its cost of sales, then the business is on track to break even. 

A price lower than that point will result in losses. A price higher than that point will start paying off the different overhead costs and operating expenses until it eventually starts making a profit.

That is why this metric is critical. As a business manager, if this figure is unknown, it will not be possible to know whether it generates a positive or negative net income. 

Also, managers may pay close attention to its COGS, as they can lower this cost as much as possible to record higher margins. Alternatively, they may use this metric to identify allocative inefficiencies that harm profits.

Another aspect in which it can play an important role is in taxes. A business with high costs will have a lower net income and pay lower taxes. However, that is not to say that a company should aim to record high COS. 

When this figure is high, it will indicate that the business will not be making big profits – although it won't pay large amounts of taxes – which can discourage its investors and shareholders. Therefore, a healthy balance must be maintained between the two sides.

Other ratios and metrics that include COGS

The cost of goods sold is essential for any business for various reasons. This figure can also calculate other accounting and financial ratios to uncover more information about the company's financial health.

1. COGS ratio

It measures the cost of goods sold as a percentage of net sales.

COGS ratio = (COGS / Net Sales) * 100

This ratio shows how much of the total sales can cover the cost of goods purchased or produced to be sold during a time period.

A high ratio shows that the costs directly going into the purchase or manufacturing of the products is high relative to the company's gross revenue. Usually, the lower this ratio gets, the better picture it paints concerning the company's financial health.

2. Gross profit margin

This metric is also a percentage that shows what amount of money a company has made as a percentage of revenue after paying for purchasing or producing goods.

Gross Profit Margin = (Revenue – COGS) / Revenue

This ratio shows how much money the business retains after paying for all the costs associated directly with producing or purchasing the goods sold to the customers.

The smaller the COS, the higher the profit margin will be. That is why managers and business owners must pay close attention to bringing down their costs as low as possible, especially in low-margin industries like grocery stores.

3. Inventory turnover

This ratio displays the number of times a merchandising company has wholly sold its inventory and restored it for sale in one accounting period.

Inventory Turnover = COGS / Average Inventory

Average inventory represents the average balance of the inventory account between the beginning and the end of the accounting year.

It is used instead of sales because inventory is always valued at cost. The higher the price, the shorter time it will take to sell the stock and restock. An inventory turnover of 5 means that the company sells and supplies merchandise five times throughout its fiscal year.

COGS in accounting

Using the cost of goods sold is accepted in the Generally Accepted Accounting Principles. GAAP lists it as a business expense and defines it as "including all the costs directly involved in producing a product or delivering a service." 

Although GAAP has narrowed its definition, it ultimately leaves the decisions concerning what expenses to include in the cost of goods sold to the accounting departments of different businesses.

Some of these expenses are very straightforward and can be easily classified into COSS, like

  • Material costs,
  • Wages directly related to the production of merchandise.

Other expenses are automatically excluded from COS, such as

  • Cost of supplies used by different departments of a company (therefore, not related to the production of goods),
  • Salaries of managers and executives.

However, for the expenses that fall into the "gray area," GAAP may not provide clear-cut rules but only guidelines by which the companies should abide.

In addition, International Accounting Standards (IAC), which were replaced by the International Financial Reporting Standards (IFRS) in 2001, have narrowed the definition of the cost of goods sold regarding what it should include.

According to IFRS, the cost of goods sold should include

  1. Purchase expenses of raw materials. These expenses include taxes, transport, handling, and all trade discounts,
  2. All costs associated with converting raw materials into products ready to be sold to the public,
  3. Other costs associated with the transportation of inventory to its destined location and conditions.

Inventory costing methods

A company's cost of sales may vary widely depending on how it values its inventory. That is because the inventory balance, both at the beginning and at the end of the year, is included in the calculation of COS.

Different methods can be used to value inventory. This is especially the case for merchandising companies that buy large quantities of homogeneous goods at different prices. Companies that purchase non-homogenous products usually use a specific identification method in valuing their inventory.

The specific identification method when the cost of each good can be found in the accounting records and thus used in valuing the inventory. 

For example, each good may have a serial or identification number that indicates which specific unit was sold in the purchase invoices.

Merchandising companies that buy large volumes of homogeneous goods need different costing methods, also known as cost flow assumptions:

1. FIFO (first-in-first-out)

This method is based on the principle that the first unit of inventory purchased is sold. If a company had purchased five units of merchandise at different costs, the first unit sold would be the first unit bought in the first place.

That is to say, the oldest purchase costs are first included in calculating the cost of sales, and the most recent purchase costs are not counted and remain in inventory.

Since the oldest merchandise is assumed to be sold first, it is expected that the first units sold would generally have a lower purchase cost than the more recent units sold. That is because we live in an inflationary economy in the long term.

Therefore, using this method will result in reporting higher net income for the company since the company will record a lower cost of sales. This means the company will have to pay more taxes using this method.

2. LIFO (last-in-first-out)

This method follows the principle opposite the one observed in the FIFO method. In this method, the goods purchased last are sold first. If a company had purchased five units of merchandise at different costs, the first unit sold would be the fifth unit bought.

This method will tend to inflate the size of the cost of sales since the more recent goods are typically purchased at a higher price. This would lower net income and make the company pay fewer taxes on its profits.

3. Average cost method

This method requires calculating the average cost of all units of merchandise purchased in calculating the cost of sales. This is done by taking the total costs of all goods in inventory and dividing that figure by the number of goods.

All items sold would therefore have the exact per-unit cost. This method helps avoid the sometimes complicated tasks of specific identification, especially for smaller-sized goods. 

However, this method cannot be practical whenever the cost of the goods purchased tends to fluctuate. Also, the average cost method is not applicable for not identical goods.

Frequently asked questions (FAQ)

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Researched and Authored by Vatche Tchelderian | LinkedIn

Reviewed and Edited by Kevin Wang | LinkedIn

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