Cost of goods sold (COGS) is an important part of accounting that applies directly to tax deductions for your business.
- Cost of goods sold (COGS) expresses how much businesses had to invest in inventory they ultimately sold throughout a certain period.
- COGS helps businesses understand a portion of their expenses but does not include overhead expenses like marketing budget.
- Businesses can also deduct COGS from their taxes, so it is important to track expenses closely.
- This article is for businesses that want to better understand accounting and financial principles like COGS and cash flow.
Cost of goods sold (COGS) is calculated by taking the value of inventory at the beginning of the period being studied, adding the cost of any new inventory purchased over the covered period, and subtracting the value of inventory held at the end of the period.
COGS = Beginning Inventory + Purchases - Ending Inventory
COGS is used to determine the company's direct cost to acquire or manufacture all its products sold during a particular period. This is important because it has a significant impact on a company's profitability over a given period.
What is cost of goods sold (COGS)?
Cost of goods sold is a company's direct cost of inventory sold during a particular period. It includes all costs directly allocated to the goods or services sold in a given week, month or year. But, it excludes any indirect or fixed costs such as overhead and marketing; it's just the cost to purchase or manufacture inventory sold in a given timeframe.
Formula for COGS
While the cost of goods sold focuses on cost, the metric is calculated in a roundabout way. Instead of totaling the cost of goods sold directly by totaling expenses, COGS is calculated by comparing the costs of beginning and ending inventory and then adding the cost of inventory acquired and sold in the covered period. In other words, the formula focuses on the timeframe, rather than expenses.
COGS = Beginning Inventory + Purchases - Ending Inventory
Of course, the formula for COGS also gets a bit more complex if you're doing your own manufacturing. In that case, Starting inventory would be cost to create that inventory,
Purchases would be the direct cost to manufacture more during the period, and Ending Inventory would be the direct cost of unsold goods.
Key takeaway: COGS measures how much you spent on goods your business sold, but does not account for overhead expenses, such as marketing costs.
Let's say there's a retail store that starts a year with a certain inventory in stock. The inventory has a retail value of $60,000 and costs the store owners $30,000 to acquire.
Now, let's say that over the ensuing year, the store owners purchase $100,000 of additional inventory, with a total retail value of $225,000. And, at the end of the year, the store has a remaining inventory worth $40,000, which had cost $20,000 to acquire.
The store's owners could use COGS to determine their total cost of inventory sold over the course of the year – a key number in determining their overall profitability for the year.
COGS = $30,000 + $100,000 - $20,000 = $110,000
In this case, the total cost of goods sold for the year would be $110,000. The store’s gross margin for the period (the gross sales for the year minus COGS) would be equal to $135,000 ($60,000 + $225,000 - $40,000 - $110,000).
Importance of COGS in accounting
In accounting, the cost of goods sold is critical for determining the profitability of a company, department or product line. It's an important metric for companies tracking the direct costs of their business inventory. It makes it easier for managers to identify cost-saving measures, including ways to save on inventory costs.
In addition to reducing wholesale costs, tracking COGS is also good for businesses to optimize their inventory ordering (reducing ordering costs), measuring inventory turnover, and minimizing their inventory holding costs.
Did you know? COGS is also an important element for maximizing your business's tax deductions. Ordinary and necessary business expenses are considered part of COGS and can usually reduce a business's tax liability.
What does COGS tell you?
COGS reveals for business owners and managers the total direct costs of their products or services sold over a certain period. This allows companies to calculate their gross profit margin on sales made during a period and is one step towards determining the company's net profit.
While COGS is a critical measure of a company's direct costs, it doesn't tell managers anything about indirect costs – things such as company overhead, salaries for back-office personnel, marketing costs and office supplies.
Inventory accounting methods and COGS
While there's just one formula for calculating the cost of goods sold, companies can choose from several different accounting methods to find their specific cost. Each method is a different way of deciding the cost of the specific items sold in a given period.
In practice, there are at least four accounting methods for determining COGS. Companies are allowed to choose from any of these, but they need to be consistent once they choose. And, while it can be difficult for companies to choose, which method they use can have a considerable impact on profitability, as well as tax consequences.
But, regardless of which method you choose, the best accounting software solutions makes it easy to use COGS in your business accounting. Some software can even help you decide on a method by showing which is most advantageous for you.
First in first out (FIFO) is an accounting method that assumes that the longest held inventory is what's sold first whenever a company makes a sale. So, if a company paid $5 per unit a year ago and it pays $10 per unit now, when it makes a sale, COGS per unit is said to be $5 per unit until all of its year-old units are sold.
While FIFO can have advantages for some businesses (such as making it easier for companies to monitor inventory turnover), it can also create higher tax liability if a company's inventory costs are consistently on the rise.
Last in first out (LIFO) is a method that considers the most recently purchased items in a company's inventory to have sold first. So, if a company paid $5 per unit a year ago and it pays $10 per unit now, each time it makes a sale, COGS per unit is said to be $10 until all of it's more recently purchased units are sold.
LIFO can offer companies significant tax advantages – especially businesses that maintain large and valuable inventories. But, if a company drastically sells down its inventory in a particular period and sells some of its "cheapest" inventory – and prices have risen since the inventory was acquired – that can cause outsized tax bills for a particular year.
The averaging method for calculating COGS is a method that doesn't consider the specific cost of individual units. It doesn't matter what was purchased when or how a company's inventory costs fluctuate. Instead, businesses using the averaging method establish an average per unit cost, and then multiply that average by the number of units sold during a particular period in order to determine COGS.
The average method is important because it represents a happy median between the FIFO and LIFO methods. It's not the most advantageous method for tax purposes, but it's not the worst, either. And, it's relatively easy to apply and to use consistently.
The specific identification method is an accounting method that allows companies to assign specific values to individual units sold in a particular period. This method can be ideal for businesses that sell custom goods or services or those with inventory that varies widely in value – a shop for valuable antiques, for instance.
Without the special ID method, COGS for businesses like these would fluctuate wildly based on what they sell in a particular period. The special identification method helps them total their COGS very accurately for a given period and can make their tax liability much more predictable.
COGS vs Expenses
While cost of goods sold is an expense for a business, it's only a portion of a company's expenses – it is just the direct expenses of a company's goods or services sold during a particular period. But, COGS doesn't include indirect costs like overhead, utilities and marketing costs.
Once it's calculated, COGS is deducted from a business's gross revenue to determine its gross margin. Other expenses are then deducted in order to calculate the business's net profits. So, while COGS are expenses, they're usually accounted for separately from other expenses (whenever possible) in order to give a company's owners and managers the most detailed picture of the business's finances.
Tip: Discuss your circumstances with a certified public accountant to determine which method is best for you. Their expertise will ensure you choose the most effective method for your business.
Limitations of COGS
Though COGS can be extremely helpful for businesses to monitor its direct costs and identify cost-saving measures, it also has its limitations. COGS doesn't show a company's true cost of selling, since it doesn't include costs like marketing. And, because COGS doesn't include fixed costs, it also doesn't provide an accurate reflection of a business's profitability.
Some other limitations of COGS include:
- True COGS can vary widely per unit sold
- COGS fluctuates based on the volume of sales in each product line
- COGS may fluctuate across periods, even when sales are level, depending on the accounting method a company uses
- Managers need to be very attentive to understand their COGS
- The impact of COGS on a company's profitability isn't always immediately clear
So, while COGS is an important metric, it's far from an accurate reflection of a company's total cost of doing business. And, while it's often listed first on a company's income or cash flow statement, in reality there are other costs that have to be paid whether a company has any sales or not.