All businesses need to track each and every cost within the organization meticulously. This is why understanding the cost of goods sold is such a vital component of your company’s success.
Cost of goods sold (COGS) refers to the direct costs of producing the goods sold by a business.
This article concentrates on the accrual accounting method within production-based industries. Service industries are not considered as they do not retain inventory, and COGS mainly looks at the cost of inventory items sold during a given period.
The cost of goods sold is recorded in the income statement, also known as the profit and loss (P&L) statement. We will learn what is included, how COGS differs from operating expenses, and how to calculate it.
Included in COGS
When determining COGS, a good rule of thumb is to ask the question–Would the cost exist if no products were produced? If the answer is no, then there is a good chance that cost is part of the cost of goods sold.
Cost of goods sold examples:
Do not factor things like administrative costs or marketing expenses into the cost of goods sold since our only focus is on production costs.
Operating Expenses vs COGS
Both operating expenses and cost of goods sold are expenditures a business incurs to create goods and services. However, unlike COGS, operating expenses are not directly related to the production of goods.
Operating expenses are SG&A: selling general, and administrative expenses. These are costs to keep the business open that would occur regardless of how many products are produced. Here are some examples below.
Operating expenses examples:
- Office supplies
- Sales and marketing
- Legal costs
Businesses within the production industry need to budget for operating expenses even though they don’t directly affect production costs.
Calculating Cost of Goods Sold
Here is the general formula for calculating COGS
We will take a deeper dive into this formula as there are four steps involved to perform this calculation.
- Identify beginning inventory of raw materials and completed goods, which are the previous period’s ending inventory.
- Determine the total cost of purchases for any raw materials and parts used in production.
- Find ending inventory – determine the total value of all items in inventory at the end of the period.
- Total up all other direct costs of production, including labor and shipping costs.
This calculation is based on the change in inventory between accounting periods. The result is the cost of the inventory made and sold by the company during the year.
FIFO and LIFO
Inventory is the biggest business asset within production-based organizations which directly affects gross profit. Inventory valuation allows you to evaluate your Cost of Goods Sold (COGS) and your profitability. The most widely used method of inventory valuation is to us FIFO & LIFO.
Since COGS subtracts ending inventory from the beginning, any change in the value of products over time could drastically alter our final calculations. Here is where FIFO or “first in, first out” comes into play.
FIFO assumes that the oldest items in the inventory were the first to be sold for accounting purposes. This does not mean that the oldest items are always sold first, but this assumption simplifies the accounting process.
LIFO, or “last in, first out,” is the opposite of FIFO. Last in, first out assumes the newest items are the first to be sold. This inventory method can offer companies significant tax advantages if a company’s inventory costs are rising.
An example of older inventory affecting valuation is seen with new car sales. A newly arrived car is worth more than the similar model that has been sitting on the lot for the past 8 months. Therefore, the longer a car is in inventory the lower the value is over time.
Using LIFO, an increase in the product’s value over the period would result in the cost of goods sold being skewed toward a higher value and vice versa if the product’s value dropped.
Tracking your cost of goods sold regularly will give you a lot of information about the productivity of your business. You will be able to tell if you are paying too much for raw materials or labor. You can also determine if you need to change the price of your finished product.
Moreover, COGS determines the profitability of your organization and is subtracted from a company’s revenue to determine the gross profit. Cost of goods sold is a direct indicator of how efficient a company is in managing its labor and supplies in the production process.
Lastly, you can take advantage of the COGS deduction on your tax return. You will need to keep meticulous records throughout all manufacturing and inventory expenses incurred during the production or acquisition of sold goods.
The FINSYNC profit and loss setting automatically compares periods such as monthly, quarterly, or yearly, so you can see trending reports.