The Cost Of Goods sold is the direct cost of the goods produced by a firm. Now, what is the direct cost? It is the cost that can be related directly to any good or service.
In this article, we will tell you everything about the cost of goods sold and how you can control it. Calculating the cost of goods will tell you how much profit you have made over the course.
The formula for finding the cost of goods
In most layman’s terms, you can say the cost of goods is the summation of beginning inventory and purchases, excluding ending inventory.
Here, your beginning inventory is the same as your last ending inventory. That is all the products you have from the last year. Purchases are anything you add, and ending inventory is what you are left with at the end, after all the selling and purchasing.
Cost Of Goods Sold = beginning inventory + all the purchases-ending inventory.
For example:- if your beginning inventory is 100 units and you make a purchase of 50 units with an ending inventory of 40, your COGS becomes 110 units.
Calculating COGS has a very important purpose in your income sheet as it will give you a precise view of your gross profits.
Calculating gross profits equals the revenue you made-your COGS.
This formula will give you an exact idea of your profits. For example, if you made a revenue of 500 units and your COGS was 110 units, your gross profits are 390 units only.
One thing to keep in mind while calculating COGS is that only the services or products bought by a consumer will be considered in any particular year, and not the costs incurred on the products that were not sold during that year. They will be considered while calculating your beginning inventory for next year.
cost of goods sold formula.
Why is COGS required?
COGS is one of the most important requirements because it shows your company’s gross profit. Its a requirement during your taxes. Firms that provide services and products need to calculate their COGS to accurately determine the amount to pay as their taxes.
The IRS allows the COAS to be included in your tax returns and overall decreases the amount you pay as your tax.
Higher COGS means the firms need to pay fewer taxes, but it also means that they are not making enough profits and that the entire issue of low profits requires a thorough check.
What is all included in COGS?
COGS includes anything and everything from the start of the idea to the final delivery. Some things that are considered in COGS are:
- Manual labor
- Rent expenses
- Insurance premiums
- Management costs
- Raw materials cost
- The cost of miscellaneous parts
- Manufacturing costs
- Packaging costs
- Fees for delivery
- Indirect costs
One simple way to determine if your expenses come under COGS is to just think if you would have made the same expenses if you knew there would be no revenue generated. If yes, then it doesnt come under COGS, and if no, then include its expense while calculating your COGS.
Cost Of Goods Sold (COGS) effects
The cost of various items you require to provide your services is not constant throughout the year. Hence, with the change in the cost of your expenses, your COGS also changes. These changes should be considered in your final calculation of COGS to satisfy the IRS.
There are four ways you can accommodate changing costs in your calculation.
1. FIFO: This method assumes that whatever goes first comes out first. Whatever is going first will be sold first. For example, if a loaf of bread goes first to be baked, itll be the first to be sold. The bakery will report old costs on income statements and new as current inventory. This method is good for any firm that has a high fluctuation in the cost of raw materials.
2. LIFO: This method takes the last what comes in as the first thatll go out. For example, you took three units, one at a different time with different cost values. Now the price goes from 100 to 105, 107. Now, if you sell two units, with LIFO, the cost of goods sold will come to 212.
The ending inventory you will have will be 100 which is the same as the cost of the oldest unit. The sequence in which you sell your units doesnt matter in LIFO. In this case, you always count backward from the last thing you acquired.
3. Average cost: As the name suggests, the average cost of all the items is calculated and you will find out your COGS through that. Just multiply the average cost per item by the final inventory cost and you will have your COGS.
4. Special Identification Method: This is the most precise method for calculating your COGS. In this, you use the exact cost of specific items to calculate the Cost Of Good Sold at every stage. In this way, you will know precisely the profits you will be making and the goodness of your business health.
Is COGS beneficial?
COGS gives you a much more defined view of your gross profits. The gross profit will be the data that will give you the degree of effectiveness in managing the raw materials and end product, or in other words, the health of your business.
There are some limitations to COGS too. Sometimes it can be manipulated and your net COGS can be increased or decreased and can give an artificial image of your profits.
Conclusion:
COGS is a tool that will give you exact data about your actual profits. In this, you consider every investment you do to provide a product or service and subtract it from your revenue generated. This cost will not include any data from the products not sold, which means COGS only includes the direct cost of any product or services purchased by the customer in a particular year.
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FAQs
What is the difference between gross profit and the cost of goods sold?
Gross profit is the difference between net sales and the cost of goods sold. It represents the amount of revenue left after deducting the direct costs of producing or acquiring the goods. Gross profit is an important indicator of a company’s ability to generate revenue and cover its production costs.
How does the cost of goods sold affect a company’s income statement?
The cost of goods sold is subtracted from net sales on the income statement to calculate gross profit. This gross profit is then used to deduct other operating expenses, such as selling, general, and administrative expenses, to arrive at the net income or profit for the period. Therefore, the COGS directly impacts a company’s profitability by influencing its gross profit margin and ultimately its net income.
Can the cost of goods sold include indirect costs?
No, the cost of goods sold typically includes only direct costs that can be specifically attributed to the production or acquisition of goods. Indirect costs, also known as operating expenses, are separate from the cost of goods sold and are deducted separately on the income statement. Indirect costs include items like rent, utilities, marketing expenses, and salaries of employees not directly involved in production.
How does the inventory valuation method impact the cost of goods sold?
The choice of inventory valuation methods, such as First-In, First-Out (FIFO), or Last-In, First-Out (LIFO), can impact the cost of goods sold. Different inventory valuation methods allocate the cost of goods sold differently, which can affect the COGS and, subsequently, the gross profit and net income. The method chosen should be consistent with industry standards and accounting principles.
How does the cost of goods sold impact pricing decisions?
The cost of goods sold plays a crucial role in pricing decisions. Businesses need to ensure that the price of their goods covers the cost of producing or acquiring them, including the COGS. By analyzing the COGS, companies can set appropriate pricing strategies to maintain profitability, considering factors such as market demand, competition, and customer value perceptions.
Also, read:
How to choose an inventory management software
What Causes Inventory Inefficiency and How to Avoid It in 2023
How To Setup Efficient Inventory Management System
Inventory Turnover Formula
