How to Calculate Cost of Goods Sold

Whether you’re running a business or investing in one, the cost of goods sold (COGS) will be a factor to watch. It will determine how large a business’ profit margin is and how much control the business has over its production-related costs such as materials and labour. 

On an income statement, the cost of goods sold represents the amount a company has paid to manufacture a product or provide a service, including materials and overhead costs related to manufacturing.  

COGS has a great deal to do with determining the price of a company’s products and its profit. Analyzing inventories and purchases related to production as well as the cost of goods sold figure that results will help business leaders monitor their company’s health and future growth. 

Calculating the cost of goods sold and what these figures mean for your business and investments are topics the experts at Hart Accounting Services know well.

In this article, we will take a look at COGS, how you can calculate them, and how this can help your business grow.

What is the Cost of Goods Sold? 

Looking at the revenue from sales is only part of the picture of a business’s health.  

A company’s financial statement, the COGS, manufacturing a product, or providing a service that has cost the company, is subtracted from the company’s revenues to find the company’s gross profit or profit before taxes. The cost of goods sold can show how efficiently a company is managing costs of materials and labour. 

Recorded as a business expense on a company’s income statements, the cost of goods sold helps investors, analysts and managers estimate the company’s bottom line. If the COGS is low, then net income should increase with time. However, a rising figure, which might be seen if key materials in the production process rise in price, will lower a company’s net income. 

The cost of goods sold can also be referred to as the cost of sales since the amount will be subtracted from sales revenue to determine income. If, for example, you were selling cabinets. COGS includes the cost of wood, hinges, screws, stains, and varnish, but it excludes rent and utilities, even though you might need an office with lighting to operate your cabinetry business.  

Operating expenses and the cost of goods sold are both listed as the cost of running a business for many companies. They’re separated on companies’ income statements because they are so different. Operating expenses are not directly related to the production of goods and services, such as office supplies, managerial salaries, and legal and insurance costs.  

How to Calculate Cost of Goods Sold 

Adding the direct costs required to produce a company’s revenues is the same as determining the cost of goods sold. This does not include fixed costs such as managerial salaries, utilities, and overhead, but more so accounts for materials that can be used in producing a product that will be sold.  

Inventory is key to determining the COGS since it figures heavily into the calculation formula. Therefore, it is important to always have a consistent and accurate process for tracking inventory within your business.

The cost of goods sold formula is simple to use. You can calculate this by using the following formula:

COGS is equal to the sum of the beginning inventory plus additional inventory minus the ending inventory.  

Inventory sold is listed under the respective account in a company’s income statement. 

The beginning inventory of the year includes merchandise that did not sell in the previous year.  Adding any additional purchases or production to the beginning inventory keeps it up to date. At year’s end, subtracting the products that did not sell from the beginning inventory and additional purchases results in the cost of goods sold.

The final number determined from this formula establishes the totals for the year.  

Accounting and Cost of Goods Sold

The value associated with the cost of goods sold depends on the accounting method used in calculating a company’s inventory. The methods include First In, First Out, or FIFO; Last In, First Out, or LIFO; and the Average Cost Method. Each of these methods can result in different COGS amounts since they arrive at inventory figures differently. 

FIFO 

In First In, First Out, simply means that the first goods a company manufactures are sold first. Since most products increase in price over time due to inflation, the FIFO method assumes that a company sells its least expensive products first. This also assumes that the cost of materials also increases in price over time, resulting in a lower cost.  

This means that if a company uses the FIFO inventory method, its net income will likely increase. If the company shows a lower cost of goods sold figure based on the FIFO method, they may be slow to realize that their net income may be decreasing and may not react quickly enough in adjusting costs or prices.  

LIFO 

In the Last In, First Out inventory accounting method is the assumption that the goods made with higher-priced materials, tending to be later in the year if prices go up over time, will be sold first. This results in a higher cost of goods sold and potentially a decreasing net income. This could lead companies to raise the prices of products in response.  

Average Cost Method 

As its name implies, the average cost method uses the average price to value the goods sold. Averaging prices tend to smooth out the rises and falls of prices when calculating the cost of goods sold. This makes the COGS less vulnerable to the impact of changing prices in materials, for example. 

What Cost of Goods Sold Doesn’t Include 

Since the cost of goods sold is the cost of making the products sold by a company, the calculation only includes expenditures related to production, such as the cost of labour, materials, and supplies and manufacturing overhead costs.  

Other costs, such as the price of marketing to increase demand for the products, managerial costs, insurance costs, and legal services, are excluded. While the cost of goods sold is useful, it will not tell you about costs that are not directly related to production. 

If an expense would have been incurred without a sale, it does not belong to the COGS. The cost of goods sold doesn’t include salaries and general administrative expenses, but labour costs directly related to specific sales can be included. 

Also, the overall cost doesn’t include making a product that did not sell. As its name implies, the COGS is the direct cost of producing goods or services that customers bought during the year.  

It is worth noting that some companies, such as purely service firms such as legal practices and accounting firms, don’t have a COGS at all. This is because these businesses usually do not have goods to sell, nor do they have inventories. 

The cost of goods sold also doesn’t include the costs of revenue to fulfill contracts such as commissions paid to sales representatives or marketing and advertising costs.  

Some service industries do have physical products to sell, too. Hotels, for example, sell the service of providing lodgings, but they might also sell foods and beverages in the hotel restaurant. In this example, the hotel would list the cost of goods sold on their income statements and claim that figure for tax purposes. 

How to use Cost of Goods Sold 

Calculating the COGS using the standard formula can help determine a company’s viability and health. The cost of goods sold formula can also help determine the proper pricing of products to create a price that’s fair for consumers and businesses alike. This allows for a healthier profit margin for the company.  

A lower COGS will suggest that the company has a higher profit margin. A rising cost of goods sold shows that the company’s profit margin and net income are declining. In the latter situation, looking for ways to decrease the costs of materials and labour or raising the price of products could be ways a business would adjust to increase its net income. 

You can calculate a company’s net income by using the following formula’s cost of goods sold:

Net income equals revenue with operating expenses, and then subtract the COGS.

The net income determines a company’s current profitability and is a clue as to how the company might perform in the future. 

However, some factors can impact the cost of goods sold that, if manipulated, can suggest that a company may be in better shape than they actually are. If accountants or managers artificially inflate an inventory, the COGS will be under-reported. This would make the company’s gross profit margin higher than in actuality and inflate its net income.  

Overstating discounts or returns to suppliers, reporting higher manufacturing costs than occurred, not writing off obsolete inventory, and altering inventory reports or overvaluing inventory on hand can all lead to deceptive reports.  

Tell-tale signs of such deception in the COGS include inventory amounts rising faster than revenue or total assets reported. An inventory build-up in a company’s financial report is another potential sign of misleading calculations.  

An accurate accounting process using the COGS formula will provide managers, investors, and analysts with an idea of the company’s profit margins within a given year.  

Why Learn How to Calculate COGS?

Calculating the cost of goods sold is key to understanding a business’s current performance and profitability. It also provides clues to past mistakes and future performance. Using the COGS formula to subtract the ending inventory from the sum of the beginning inventory and additional purchases is important whether you are a CEO, manager, investor, or financial analyst.  

Knowing how to determine this figure using the cost of goods sold formula will also be a crucial part of auditing a business to increase its profit margin. A rise in the COGS will indicate an increase in product pricing might be needed to stop its net income from decreasing.  

If a product’s price doesn’t increase to offset the cost of goods sold, there may be other ways to adjust for a rising total, such as decreasing the size of the product or finding ways to save money on materials, labour, or both. 

The cost of goods sold formula can help businesses in planning steps to protect and grow profit margins and set prices correctly. COGS can also help investors analyze a business’s net income and profit margins.  

While the cost of goods sold doesn’t include key components of a business’s operations, such as overhead expenses and those related to products that have not been sold yet, the COGS will show the cost of creating revenue. This will show whether the company is turning a profit and how much of a profit.  

Summary

Having the most accurate figures in your company’s financial report is vital in planning, investing, and accounting. That’s where Hart Accounting Services can help.  

Hart Accounting Services, a group of independent businesses in Ontario, provides customers with the highest level of customer satisfaction. We work to earn our customers’ trust through professionalism, accuracy, and accounting advice. 

Hart Accounting Services offers a full range of tax and accounting solutions for businesses of all types and sizes. Performance tracking, regulatory compliance, and tax advice from Hart Accounting Services will help your business run smoothly and free your resources for other parts of your business operation.  

Corporate accounting, bookkeeping, HST filings, payroll services, tax preparation, and the preparation of financial statements are among the services Hart provides to its clients. 

Calculating the cost of goods sold is only one part of the accounting picture. Hart Accounting Services experts in Ontario have the knowledge to translate what these numbers mean and how they can result in a healthier bottom line for your business.