Cost of Goods Sold (COGS), Definition, Calculation, Formula and Example

What is Cost of Goods Sold? How to calculate it using the formula with Example

You must have come across the term Cost Of Goods Sold or simply called  COGS when you meet your accountant or at a corporate meeting.

If you’ve wondered ever what is it and why is it so much important then this article is for you.

Let’s first understand the term Cost of Goods Sold.

What is Cost of Goods Sold?

Cost of Goods Sold (COGS) is a direct cost of the production of the goods or products sold by a company. This amount includes the additional material charges as well which are used for the delivery and packaging of the goods.

However, it excludes indirect costs such as sales & marketing.

Why is it important to know and calculate the Cost of Goods Sold?

The primary motive of starting any business is to earn a profit. A business person can earn profit only when he knows his exact expenses and incomes by selling his/her goods.

Cost of Goods Sold gives the idea to a business person about his expenditure in procuring the material he wants to sell. Therefore, it becomes an important part of his finances. Here are some of the benefits of knowing Cost Of Goods Sold (COGS).

  • Helps in creating a pricing strategy
    Firstly, your selling price can be determined by knowing the total expense you have made in procuring the products. Once you know the amount in which you have purchased the product, you will be in a better position to judge the price at which you would like to sell the product so that you can not only cover your expenses but also earn profit from it.
    Hence, knowing COGS helps you in determining how much profit margin you can keep on the products you sell.
  • Helps in determining the actual expenses in obtaining the products
    Now, this is more of an accounting thing but none the less it is important. Your balance sheet needs to list all your expenditures and incomes. So knowing the amount you have spent in getting the products to be sold you can arrive at actual expenses by including other costs incurred in the overhead i.e. sales and marketing.
  • Helps in comparing the market value of your product with your competitors
    Once you know the exact purchasing amount and thereafter deciding your profit margin is not an ideal strategy. Chances are that you might have added more profit margin or less in comparison to your competitors in the market. In such a situation, if your prices are high in the market then nobody will purchase your product and you will incur a loss. If the prices are lower than your competitors then also you will incur loss since you are having a low-profit margin.Hence, COGS indirectly helps you in selling your product at the right price that can get you more sales and thereby, also help in earning profit.

Now that you know the importance of calculating the COGS, let’s learn how to calculate COGS using a formula.

How to calculate the Cost Of Goods Sold using a formula?

So, without wasting any more time, here’s the Cost of Goods Sold formula:

COGS = Beginning Inventory + Purchases made during the period – Ending Inventory

The cost of goods sold equation, although being a bit strange, certainly makes sense.

To calculate the overall annual spendings, you will always have to start from the beginning inventory. There are chances that some new items were introduced in the beginning inventory, so a new inventory that is purchased is added to the old one. Now, as we are to calculate how much of the inventory was sold, subtract the ending inventory.

Example of COGS

Let’s assume that ‘x’ business uses the calendar year to record their inventory. Now, the beginning inventory was recorded on 1st January and the ending inventory was recorded on 31st December.

The beginning inventory cost was $20,000. While the sales were on, the retailer realized that the business might need an additional inventory worth $7,000. At the end of the calendar year, the ending inventory proved out to be worth  $4,000. Now, let’s try to find the Cost of Goods Sold for the entire year by calculating with our formula.

COGS = Beginning Inventory + Purchases made during the period – Ending Inventory

COGS = $20,000 + $7,000 – $4,000

Therefore, COGS = $23,000.

The cost of goods sold equals $23,000, as calculated. Now, this figure will help you with fair decisions, choosing vendors with direct material prices, etc.

As the COGS is calculated, this can also help you to calculate your yearly gross income. Suppose, your annual revenue is $75,000.

Now, with the cost of goods sold statement in your hands, your gross income will be $75,000 – $23,000 = $52,000.

COGS – the key business takeaways

  • The COGS is a vital metric that is displayed on your financial statements as it is the only figure that gets subtracted from the business revenue to get its gross profit. The gross profit is a profitability measure that shows how well a business can manage its labor and supplies in the production process.
  • When talking about an automobile business, there are high chances that the selling figures might fluctuate at the end of the year. There is a tremendous impact on the resale value when it comes to the model of the car, wherein the build-year plays an important role. Because of this, even the COGS varies due to fluctuation in the ending inventory; possibilities of either having an immense profit in the business or vice-versa.
  • The value of COGS will always depend on the accounting standards that are used in the calculations.

To conclude…

As inventory is a valuable asset, till the time the product or the goods remain a part of that inventory, the amount of that product remains in the asset account. As soon as the product is sold, that amount (along with all the additional charges) goes into the expense amount which is also called ‘cost of goods sold’.

COGS always appears on the profit and loss statement and is also used for inventory control measurements.

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