As a business owner, accurately understanding how to calculate cost of goods sold is an essential element of effective financial management. By mastering the cost of goods sold (COGS), you can make informed decisions and identify opportunities to enhance your company's success. In this blog post, Viindoo will delve into the intricacies of COGS, highlight its significance, and provide you with in-depth information on how to calculate it accurately.
What is Cost of Goods Sold (COGS)?
Cost of goods sold (COGS) is a key component of a company's income statement. It represents the direct costs incurred in the production and sale of a product. These costs include materials, labor, and overhead directly related to the manufacturing process. Essentially, cost of goods sold reflects the amount of money a company spent to create the products it sold.
Cost of goods sold is an essential measurement for businesses because it directly affects the company's profits. By calculating cost of goods sold, businesses can determine the true cost of their products and make informed decisions about pricing, inventory management, and overall financial health.
What is Cost of Goods Sold (COGS)?
Why You Need to Know Cost of Goods Sold
Knowing your COGS is crucial for several reasons:
- Pricing: COGS is a significant factor in determining the price of your products. If you don't know your COGS, you may end up setting prices too low, resulting in lower profits, or too high, leading to decreased sales.
- Inventory Management: COGS also plays a vital role in managing your inventory. By understanding your COGS, you can determine the optimal level of inventory to maintain, preventing overstocking or stock shortages.
- Financial Analysis: COGS is a critical metric for analyzing the financial health of your business. It allows you to compare your costs to your revenue and identify areas where you can cut costs or increase efficiency.
How to Calculate Cost of Goods Sold
Calculating COGS involves several steps, and the method may vary depending on your business type. In general, there are two main methods for calculating COGS: the periodic inventory method and the perpetual inventory method.
Periodic Inventory Method
The periodic inventory method is used by businesses that do not track their inventory levels continuously. Instead, they conduct a physical count of their inventory at the end of an accounting period to determine the cost of goods sold. Here's how to calculate COGS using the periodic inventory method:
- Determine Beginning Inventory: The first step is to determine the value of your inventory at the beginning of the accounting period. This includes all the products you had in stock from the previous period.
- Add Purchases: Next, add the cost of all the inventory purchased during the accounting period. This includes the cost of raw materials, labor, and any other direct expenses associated with producing the products.
- Subtract Ending Inventory: To determine the cost of goods sold, subtract the value of your ending inventory from the total of your beginning inventory and purchases. The resulting amount is your COGS for the period.
Perpetual Inventory Method
The perpetual inventory method is used by businesses to monitor their inventory levels continuously. With this method, the cost of goods sold is calculated each time a product is sold, rather than at the end of the accounting period. The calculation method is similar to the periodic inventory method. However, due to its complexity, businesses often employ the perpetual inventory system to facilitate this process.
What Are Different Accounting Methods For COGS?
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.
- First-in-first-out (FIFO)
- Last-in-first-out (LIFO)
- Average costing method
- Specific identification
>>>> Note: LIFO is not allowed under IFRS (International Financial Reporting Standards) because it does not reflect the actual flow of goods, and it can result in outdated values of inventory.
It's important to note that the accounting method chosen for COGS must be consistent and cannot be changed without proper justification.
Exclusions from Cost of Goods Sold
Although cost of goods sold includes most direct costs associated with the products manufactured and sold, there are some exclusions that businesses should be aware of. These include:
- Indirect Expenses: Indirect expenses, such as rent, utilities, and administrative costs, are not included in COGS. These expenses are recorded separately on the income statement.
- Marketing and Advertising Costs: Costs related to marketing and advertising are not included in COGS. These expenses are considered selling expenses and are also recorded separately on the income statement.
- Research and Development Costs: Any costs associated with research and development are not included in COGS. These expenses are considered part of the company's operating expenses.
Cost of Goods Sold Formula for Retailers
For retailers, calculating COGS is relatively straightforward. The cost of goods sold formula for retailers is:
Beginning Inventory + Purchases - Ending Inventory = COGS
To better understand this formula, let's break it down into its components:
- Beginning Inventory: This includes all the products you had in stock at the beginning of the accounting period.
- Purchases: This includes the cost of all the inventory purchased during the accounting period, including raw materials, labor, and other direct expenses.
- Ending Inventory: This is the value of your inventory at the end of the accounting period.
Once you have calculated your COGS, you can use this information to determine your gross profit by subtracting COGS from your total sales revenue.
| Beginning Inventory | $10,000 |
| + Purchases | $5,000 |
| - Ending Inventory | $12,000 |
| = Cost of Goods Sold | $3,000 |
Cost of Goods Sold Formula for Manufacturers
For manufacturers, calculating COGS is a bit more complex as it involves factoring in the cost of raw materials, labor, and overhead expenses. The cost of goods sold formula for manufacturers is:
Beginning Inventory + Purchases + Direct Labor + Manufacturing Overhead - Ending Inventory = COGS
Let's take a closer look at each component of this formula:
- Beginning Inventory: This includes the value of all the raw materials and work-in-progress inventory at the beginning of the accounting period.
- Purchases: This includes the cost of all the raw materials purchased during the accounting period.
- Direct Labor: This includes the wages and benefits paid to employees directly involved in the production process.
- Manufacturing Overhead: This includes all indirect costs associated with manufacturing, such as rent, utilities, and equipment maintenance.
- Ending Inventory: This is the value of your finished goods inventory at the end of the accounting period.
By subtracting your COGS from your total sales revenue, you can determine your gross profit margin, which is a key indicator of your company's financial health.
How to Report COGS on an Income Statement
COGS is reported on the income statement as a separate line item below the revenue section. It is typically listed as the first expense item and is deducted from the total sales revenue to determine the gross profit. Here's an example of how COGS is reported on an income statement:
|
+ Revenue from contracts with customers
| $100,000 |
|
- Deductions
| $2,000 |
| = Revenue | $98,000 |
- Cost of Goods Sold | $48,000 |
= Gross profit | $50,000 |
It's important to note that COGS is only one component of the income statement and does not include all expenses associated with running a business. Other expenses, such as operating expenses and taxes, are also included in the income statement.
How to Calculate Cost of Goods Sold using Viindoo software
Above, we have learned the principles of determining the cost of goods sold. Next, we will explore how Viindoo software calculates the cost of goods sold using the FIFO inventory valuation method and the perpetual Inventory system (automatic).
Configuration of Product Categories in one setup step
The user needs to set up as this image, that's all.
Configuration of Product Categories in one setup step
Each product on Viindoo is set up to be associated with a certain product group. That allows you to set up only once for many products with similar properties, types and the same warehouse management method.
Configuration of Products
Make Sales
When you make a sale products, Viindoo will automatically calculate the cost of goods sold (COGS) using the FIFO method.
Create sale order products with the FIFO inventory costing method Viindoo
Manage your inventory - As you purchase new inventory items and sell existing ones, Viindoo software will automatically track all of your inventory movements, costs, and quantities. This ensures that your COGS and ending inventory values are always accurate based on the FIFO method.
Inventory report in Viindoo
>>>> Note: For manufacturing companies, the cost of goods manufactured is calculated by dividing the cost of goods manufactured by the total number of goods produced, multiplied by the number of goods sold in the warehouse. We have a separate article on Manufactured Product Costs - this is a very complex issue. See more details in the article: Cost of goods manufactured.
Accounting and Reporting
Applying Viindoo software in calculating Cost of Goods Sold not only helps businesses calculate the cost of goods automatically with just simple settings but also allows accounting arisings to be recorded automatically. From there, data is always ready to provide reports: inventory reports, inventory valuation reports, profit and loss reports, etc.
Inventory report in Viindoo
P&L report in Viindoo: COGS
With general management software like Viindoo, all worries about manual operations, manual accounting, delayed and non-instant reports have been eliminated. Now, businesses can completely optimize their finances and develop their business with wise and timely decisions. Businesses can fully automate management, accounting, and collaborative work with the Viindoo ecosystem: accounting software, purchasing software, sales software, warehouse software etc., and a variety of built-in features. See more at: Viindoo's overall business management solution.
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Cost of Goods Sold (COGS) refers to the direct costs incurred by a company in the production and sale of its products. It includes the expenses related to materials, labor, and overhead directly associated with manufacturing. COGS is important for businesses because it directly impacts the company's profitability. By accurately calculating COGS, businesses can determine the true cost of their products, make informed pricing decisions, manage inventory effectively, and assess their overall financial health.
There are two main methods for calculating COGS: the periodic inventory method and the perpetual inventory method.
Beginning Inventory + Purchases - Ending Inventory = COGS
Beginning Inventory represents the value of the products in stock at the beginning of the accounting period. Purchases include the cost of all inventory purchased during the period, including raw materials, labor, and other direct expenses. Ending Inventory represents the value of the remaining inventory at the end of the period. By subtracting the ending inventory value from the sum of beginning inventory and purchases, businesses can determine their COGS.
Beginning Inventory + Purchases + Direct Labor + Manufacturing Overhead - Ending Inventory = COGS
In addition to beginning inventory, purchases, and ending inventory, manufacturers also consider direct labor costs and manufacturing overhead. Direct labor includes wages and benefits paid to employees directly involved in the production process, while manufacturing overhead encompasses indirect costs such as rent, utilities, and equipment maintenance. By subtracting the ending inventory value from the sum of all these components, manufacturers can determine their COGS.
COGS is reported on the income statement as a separate line item below the revenue section. It is typically listed as the first expense item and is deducted from total sales revenue to determine the gross profit. Other expenses, such as operating expenses and taxes, are also included in the income statement. COGS provides insight into the direct costs associated with the production and sale of products, while operating expenses capture the indirect costs of running the business.
Conclusion
In conclusion, understanding and accurately calculating cost of goods sold (COGS) is crucial for businesses of all sizes. It allows you to determine the true cost of your products, make informed decisions, and improve your business's profitability. For a simplified and efficient COGS calculation process, consider using Viindoo, a comprehensive business management software that includes COGS tracking and analysis features. With Viindoo, you can streamline your financial management and take your business to new heights.
