What It Measures
For a retailer, cost of goods sold (COGS) is the cost of buying and acquiring the goods that it sells to its customers. For a service company, COGS is the cost of the employee services it supplies. For a manufacturer, COGS is the cost of buying the raw materials and manufacturing its finished products.
Why It Is Important
Cost of goods sold may help a company to determine the prices to charge for its products and services, and the volume of business that it needs to maintain in order to operate profitably.
For retailers especially, the cost of the merchandise sold is typically the largest expense, and thus is an absolutely critical business factor. However, understanding COGS is an important success factor for any business because it can reveal opportunities to reduce costs and improve operations.
COGS is also a key figure on an income statement, and an important consideration in computing income taxes because of its close relationship to inventory, which tax authorities treat as future income.
How It Works in Practice
Essentially, COGS is equal to a company’s opening inventory of goods and services, plus the cost of goods bought and direct costs incurred during a particular period, minus the closing inventory of goods and services.
A critical consideration is the accounting policy that a company adopts to calculate inventory values, especially if raw materials prices change during the year. This may happen often, particularly when inflation is high. Inventory values under a first in first out (FIFO) policy reflect original or older prices of materials, while a last in first out (LIFO) policy reflects current (and often more
expensive) prices. Somebody computing COGS first needs to know which policy is being used, because this will affect inventory values.
COGS for a manufacturer will include a variety of items, such as raw materials and energy used in production, labor, benefits for production workers, the cost of raw materials in inventory, shipping fees, the cost of storing finished products, depreciation on production machinery used, and factory overhead expenses.
For a retail company such as Wal-Mart, COGS is generally less complex: the total amount paid to suppliers for the products being sold on its shelves.
COGS is calculated as follows:
|Inventory at beginning of period||$20,000|
|Purchases during period||+ $60,000|
|Cost of goods available for sale||= $80,000|
|Less inventory at period end||– $15,000|
|Cost of goods sold (COGS)||= $65,000|
Because the counting of inventory is an exhaustive undertaking for retailers, doing it quarterly or monthly would be open to error. Accordingly, tax authorities allow them to estimate cost of goods sold during the year.
Determining these estimates requires details of the gross profit margin (retailers typically use the preceding year’s figure). This figure is then used to calculate the cost ratio.
Begin by assuming that net sales are 100%, then subtract the gross profit margin, say 40%, to produce a cost ratio of 60%: 100% – 40% = 60%. A monthly COGS calculation then looks like this:
|Inventory at beginning of month||$10,000|
|Purchases during month||+ $25,000|
|Cost of goods available for sale||= $35,000|
|Less net sales during month||– $28,000|
|Cost ratio 100% – 40%||= 60%|
|Estimated cost of goods sold||= $16,800 ($28,000 × 60%)|
There is one example to review, because calculating COGS for manufacturers requires additional factors:
|Inventory at beginning of year||$20,000|
|Purchases during year||+ $50,000|
|Cost of direct labor||+ $15,000|
|Materials and supplies||+ $12,000|
|Misc. costs||+ $3,000|
|Total product expenses||= $100,000|
|Less inventory at year end||– $15,000|
|Cost of goods sold (COGS)||= $85,000|
Tricks of the Trade
Anyone who wants to determine COGS must maintain inventory and know its value!
Because goods returned affect inventory values and, in turn, cost of goods sold, returns of goods must be reflected in COGS calculations.
Merchandising companies may use different inventory accounting systems, but the choice has no bearing on the actual costs incurred; it only affects allocation of costs.
COGS should not include indirect costs like administration and marketing costs, or other activities that cannot be directly attributed to producing or acquiring the product.