Cost of Goods Sold: What It Is & How To Calculate It
Tim is a Certified QuickBooks Time (formerly TSheets) Pro, QuickBooks ProAdvisor, and CPA with 25 years of experience. He brings his expertise to Fit Small Business’s accounting content.
Eric is a staff writer at Fit Small Business and CPA focusing on accounting content. He spends most of his time researching and studying to give the best answer to everyone.
This article is part of a larger series on Bookkeeping.
Cost of goods sold (COGS) represent the total costs in making or purchasing a product. In simpler words, COGS is the amount you paid when you produced or purchased the products that were sold during the period. Selling costs like commissions are not part of COGS. Rather, these are recorded as part of operating costs.
Calculating COGS depends on the kind of inventory system you use. Under the perpetual inventory system, COGS are computed automatically every time there is a sale to customers. In the periodic inventory system, you count the beginning and ending inventory manually and then compute COGS using the formula below:
Beginning inventory | xxx |
Add: Purchases or Production | xxx |
Cost of goods available for sale | xxx |
Less: Ending inventory | xxx |
Cost of goods sold | xxx |
COGS computation also depends on the kind of cost flow assumption you use. Check out our articles below for a more detailed discussion of COGS computation using the:
- Average cost method
- Last-in, first-out (LIFO) method
- First-in, first-out (FIFO) method
- Specific identification method
What Is the Purpose of COGS?
Cost of goods sold is an important line item in the income statement—manufacturers and retailers should present COGS as a deduction to gross sales to arrive at the gross profit:
- Determines gross profit: COGS is an important metric that affects your business’ overall profitability, and the level of COGS affects your gross profit margin.
- Assesses level of costs: Since most costs included in COGS are direct costs, businesses can control and reduce these costs to increase gross profit. For example, buying raw materials at a lower price from another supplier can reduce COGS and increase profitability.
- Assesses resource efficiency: Knowing your business’ COGS is one way of assessing if you’ve been efficient and effective in using business resources to generate revenue. Higher COGS without increase in revenues might indicate inefficient use of resources.
- Determines inventory turnover: COGS is also an essential component of the inventory turnover ratio, which determines the speed at which inventory is sold to customers. You use the ratio to analyze business activity and its relationship with overall profitability. Moreover, if you have a low inventory turnover, it’s possible that COGS are also low, which is a possible indicator of slow sales. You may want to generate an inventory aging report to investigate why COGS are low and determine if this is normal in your industry or line of business.
What Costs Are Included in COGS?
There are specific costs that can be included in cost of goods sold, and they depend on the type of business. Check the table below to see the common costs included in COGS for merchandising and manufacturing businesses:
Merchandising | Manufacturing |
|---|---|
|
|
COGS is an important aspect of inventory management. Our bookkeeping guide discusses in greater detail why determining COGS is an important bookkeeping responsibility.
COGS Computation Example
For this example, let’s assume that we have $500 worth of beginning inventory. During the month, we purchased inventory for $2,000. At the end of the month, the remaining inventory on hand is $600. The cost of goods sold during the month is calculated below:
Beginning inventory | $500 |
Add: Purchases or Production | $2,000 |
Cost of goods available for sale | $2,500 |
Less: Ending inventory | $600 |
Cost of goods sold | $1,900 |
By using small business accounting software, you can calculate the cost of goods sold in every sale transaction automatically. Check out our roundup of the best small business accounting software to learn about the leading platforms.
COGS vs Operating Expenses
Both cost of goods sold and operating expenses are amounts that reduce net income. However, these two have different functions. COGS are expenses that are directly related or tied to the manufacturing or purchase of goods for sale. Meanwhile, operating expenses are expenses not directly related to products sold.
Examples of operating expenses include rent, office supplies, accounting and bookkeeping, and payroll. These expenses can’t be traced to the main products, but the whole business benefits from these costs.
Frequently Asked Questions (FAQs)
In general, salaries are part of operating expenses. However, salaries and wages that are directly related to products can be included in the cost of goods sold. For instance, the salary of a production supervisor can be part of COGS since the line of work is directly related to the production of goods. In contrast, the salary of accounting supervisors or vice presidents of the company cannot be part of COGS.
Yes. The terms are interchangeable because they pertain to the cost to produce a good or perform a service.
Bottom Line
Knowing the cost of goods sold is crucial accounting knowledge, especially for decision-making. The behavior of COGS in the business can help you determine whether it’s possible to lower costs to boost gross profit or stimulate sales. Moreover, being familiar with the composition of COGS can provide insights into specific areas that contribute to a high COGS.
