What Is Cost of Goods Sold (COGS)? (Defined and Calculated)

What is Cost of Goods Sold (COGS)?

Cost of goods sold (COGS) is a financial metric that tells how much cost the company incurs to produce the product or services they successfully sell to the consumers. 

It is important to note that the COGS metric is calculated for the sold goods (product) only.

It measures the direct cost incurred, such as material, labor, factory, and other costs involved in product production.   

In modern tech-based businesses like SaaS, the cost of goods sold is computed over web designing and development, hosting and monitoring costs, account management, license fees, support costs, training, professional services, and subscriptions.

How To Calculate the Cost of Goods Sold?

COGS metric is helpful for the managers and stakeholders to keep track of the performance and profitability of the business. Businesses need it to determine their gross profit and margins.

Cost of goods sold formula:

Where;

B.I = beginning inventory

P=Purchases during the period

E.I = ending inventory

Beginning inventory is the value of goods in the company’s inventory at the start of an accounting period. 

Ending inventory is the amount of goods produced that the company didn’t sell yet, and hence the amount is still in hand at the end of the reporting period. 

Accounting for COGS 

Four methods are there for inventory and COGS accounting: 

• First-in, first-out (FIFO): Companies first sell the goods manufactured at the earliest.

• Last in, first-out (LIFO): The company first sells the goods manufactured last.

• Weighted average: Businesses average the costs of the goods in stock to evaluate the goods sold. 

• Specific identification: Costs are directly accredited and attributed to the unit sold. 

Limitations of COGS 

The primary issue with COGS is that the accounting individual can manipulate it to alter and show improved stats. 

The common ways include:

• Stating inflated discounts
• Overvalued returns 
• Variations in inventory in stock at the end of the accounting period
• Overstated in hand inventory

What Is the Cost of Goods Sold Example?

Suppose an ABC e-commerce site sells jewelry, and we want to find out the cost of goods sold. The company must begin by finding the value of its beginning inventory.

Pro tip: beginning inventory is the value of the previous year’s end inventory. 

They will now add the cost of producing the jewelry to the starting value.

Pro tip: purchase costs include labor costs, shipping costs to customers, and raw materials.

Lastly, subtract the inventory value from the value and costs of the beginning. This subtraction will give ABC the value of the exact cost of goods sold for their business.

Now let’s look at the numerical cost of goods sold example to understand better. 

At the beginning of the month, a company has about $15,000 worth of inventory. The purchase is a total of $7000 for the quarter. By the end of the inventory, you have $4000 in hand. 

Using the cost of goods sold formula:

Cost of Sales vs. Cost of Goods Sold

Any business that wants to thrive in the marketplace must have the cost of goods sold and the cost of sales in their company’s income statement.

These two terms will help the company make good financial decisions and strategically invest in the future.

Most businesses often use these two terms interchangeably, although they have some key differences.

The cost of sales is also known as the cost of revenue. It refers to the accumulated cost that the business incurs when creating a good or service for the customers. 

Cost of sales includes the number of goods sold, whereas the cost of goods sold calculates the manufacturing of the number of goods. 

The cost of goods sold refers to the company’s cost for crafting products from the raw materials. It also includes buying and reselling goods too.

There are two types of costs included in the cost of goods sold:

• Direct costs

These are costs directly related to making the product, such as the raw materials cost, shipping costs, and so on.

• Indirect costs

These costs go beyond the production of goods, such as distribution and warehouse utility costs.

Retail companies use the cost of sales. On the other hand, manufacturing and trading companies use the cost of goods sold.

The cost of sales is not tax-deductible, whereas the cost of goods sold is tax-deductible.

Cost of sales is a much broader term than the cost of goods sold. At the same time, the cost of goods sold is narrower in comparison to the cost of sales. 

In the income statement cost of sales is mentioned before the EBIT margin. Busines report the cost of goods sold after revenue in the income statement.

The cost of sales analyzes the direct and indirect cost of goods and services sales. 

The cost of goods sold analyses only the direct cost of the production of goods and services.