Home » Bookkeeping articles » How to Calculate the Cost of Goods Sold

# How to Calculate the Cost of Goods Sold

August 2, 2024
Bill Kimball

Any money your business brings in over the cost of goods sold for a time period can be allotted to overhead costs, and whatever is leftover is your business’s profit. Without properly calculating the cost of goods sold, you will not be able to determine your profit margin, or if your business is making a profit in the first place. Cost of Goods Sold (COGS) is the direct cost of a product to a distributor, manufacturer, or retailer. Sales revenue minus cost of goods sold is a business’s gross profit. The special identification method uses the specific cost of each unit of merchandise (also called inventory or goods) to calculate the ending inventory and COGS for each period.

## What’s included in cost of goods sold?

FIFO and specific identification track a single item from start to finish. This includes direct labor cost, direct material cost, and direct factory overheads. It does not include indirect expenses, such as sales force costs and distribution costs. The FIFO method assumes the first goods produced or purchased are the first sold, whereas the LIFO method assumes the most recent products produced or purchased are the first sold. The average cost method uses the average cost of inventory without regard to when the products were made or purchased. Understanding these components helps businesses accurately calculate COGS, ensuring they have a precise measure of their production costs.

1. It doesn’t, however, state what order inventory is deemed to be sold.
2. If the inventory value included in COGS is relatively high, then this will place downward pressure on the company’s gross profit.
3. And not all service-based businesses keep track of cost of goods sold — it depends on how they use inventory.
4. COGS is not addressed in any detail in generally accepted accounting principles (GAAP), but COGS is defined as only the cost of inventory items sold during a given period.

## What is cost of goods sold (COGS)? Cost of goods sold formula

IFRS and US GAAP allow different policies for accounting for inventory and cost of goods sold. Very briefly, there are four main valuation methods  for inventory and cost of goods sold. Our partners cannot pay us to guarantee favorable reviews of their products or services. Levon Kokhlikyan is a Finance Manager and accountant with 18 years of experience in managerial accounting and consolidations.

## Are labour costs included in the cost of goods sold?

The calculation for COGS depends on the inventory costing method used by a company. If your company can find other suppliers of soap ingredients that you can only spend \$4 on ingredients per bath soap, then the COGS will be reduced to \$6 per bath soap. But of course, there are exceptions, since COGS varies depending on a company’s particular business model. Under the matching principle of accrual accounting, each cost must be recognized in the same period as when the revenue was earned. Access and download collection of free Templates to help power your productivity and performance. A financial professional will offer guidance based on the information provided and offer a no-obligation call to better understand your situation.

The basic purpose of finding COGS is to calculate the “true cost” of merchandise sold in the period. It doesn’t reflect the cost of goods that are purchased in the period and not being sold or just kept in inventory. It helps management and investors monitor the performance of the business. Whether your business manufactures goods or orders them for resale will influence what types of costs you are likely to include. And not all service-based businesses keep track of cost of goods sold — it depends on how they use inventory.

Instead, they have what is called “cost of services,” which does not count towards a COGS deduction. Any additional productions or purchases made by a manufacturing or retail company are added to the beginning inventory. At the end of the year, the products that were not sold are subtracted from the sum of beginning inventory and additional purchases.

This relationship portrays how COGS is used to assess how efficient the company is in managing its supplies and labor in production. COGS represents the actual costs incurred to produce and sell goods, so it should always be a positive value or zero. By subtracting 1 by the gross margin, we can derive the COGS margin. Throughout Year 1, the retailer purchases \$10 million in additional inventory and fails to sell \$5 million in inventory. The calculation of COGS is distinct in that each expense is not just added together, but rather, the beginning balance is adjusted for the cost of inventory purchased and the ending inventory. The categorization of expenses into COGS or operating expenses (OpEx) is entirely dependent on the industry in question.

Cost of goods sold, often abbreviated COGS, is a managerial calculation that measures the direct costs incurred in producing products that were sold during a period. In other words, this is the amount of money the company spent on labor, materials, and overhead to manufacture or purchase products that were sold to customers during the year. Cost of goods sold does not include costs unrelated to making or purchasing products for sale or resale or providing services.

Creditors and investors also use cost of goods sold to calculate the gross margin of the business and analyze what percentage of revenues is available to cover operating expenses. Generally speaking, only the labour costs directly involved in the manufacture of the product are included. In most cases, administrative expenses and marketing costs are not included, though they are an important aspect of the business and sales because they are indirect costs.

With the same selling price of bath soap, this helps your company increase your margin without jeopardizing quality. Utilizing our cost of goods sold calculator, we aim to help you assess the total cost incurred of producing and selling goods. For more detailed analysis, explore our inventory turnover calculator and margin calculator.

COGS only applies to those costs directly related to producing goods intended for sale. Shaun Conrad is a Certified Public Accountant and CPA exam expert with a passion for teaching. After almost a decade of experience in public accounting, he created MyAccountingCourse.com to help people learn accounting & finance, pass the CPA exam, and start their career. During times of inflation, FIFO tends to increase net income over time by lowering the COGS.

The balance sheet only captures a company’s financial health at the end of an accounting period. This means that the inventory value recorded under current assets is the ending inventory. Income statements are one of the three most important financial documents in your repertoire—and learning how to draw one up is a crucial step in understanding your business’s financial trajectory. To get more info on how to build your own report, check out our page on how to prepare an income statement.

We follow strict ethical journalism practices, which includes presenting unbiased information and citing reliable, attributed resources. At Finance Strategists, we partner with financial experts to ensure the accuracy of our financial content. One way to reduce your COGS is to negotiate better prices from your suppliers. Let us say XYZ Company wants to calculate COGS in the first quarter of 2022. The cost of goods sold is an important metric for a number of reasons.

Costs of revenue exist for ongoing contract services that can include raw materials, direct labor, shipping costs, and commissions paid to sales employees. These items cannot be claimed as COGS without a physically produced product to sell, however. The IRS website even lists some examples of “personal service businesses” that do not calculate COGS on their income statements. Cost of goods sold (COGS) is calculated by adding up the various direct costs required to generate a company’s revenues. Importantly, COGS is based only on the costs that are directly utilized in producing that revenue, such as the company’s inventory or labor costs that can be attributed to specific sales. By contrast, fixed costs such as managerial salaries, rent, and utilities are not included in COGS.

Cost of Goods Sold is also known as “cost of sales” or its acronym “COGS.” COGS refers to the direct costs of goods manufactured or purchased by a business and sold to consumers or other businesses. COGS counts as a business expense and affects how much profit a company makes on its products. Cost of goods sold is the term used for manufacturers on their costs spent to produce a product. Cost of sales is typically used by service-only businesses because they cannot list COGS on their income statements. Examples of businesses using the cost of sales are business consultants, attorneys, and doctors.

For example, if you are a manufacturing company, you may want to invest in machinery that can automate some of the production processes. Improving your bottom line also means finding ways to automate and streamline processes. COGS and operating expenses are different sets of expenditures incurred by the business in running their day-to-day operations. Using the FIFO method, COGS for each of the 80 items is \$15/item because the first goods purchased are accounted to be the first goods sold. You also have to spend \$1 per bath soap on the labor required to craft it and \$1 for packaging.

Many service companies do not have any cost of goods sold at all. COGS is not addressed in any detail in generally accepted accounting principles (GAAP), but COGS is defined as only the cost of inventory items sold during a given period. Not only do service companies have no goods to sell, but purely service companies also do not have inventories. If COGS is not listed on a company’s income statement, no deduction can be applied for those costs. It’s subtracted from a company’s total revenue to get the gross profit.

You might be surprised to find that you’re making less profit than you expected with certain products. By analyzing the cost of goods sold for certain products, you can change vendors to order cheaper materials or raise your prices to increase your profit. Calculating the cost of goods sold, often referred to as COGS in accounting, is essential to determining whether your business is making a profit. It involves a simple formula and can be calculated monthly to keep track of progress or even less frequently for more established businesses.