How to Compute Cost of Goods Sold (COGS)
Instructions to Cost Goods and Achieve Optimal Gross Profit!
On any income statement, the cost of goods sold (COGS) is a linchpin figure. It is the direct expense of producing the products a company sells during a period. It's important to understand how to calculate cost of goods sold for pricing, profitability analysis, tax reporting and inventory valuation. In this guide we go through the cost of goods sold formula, what to include, examples and a few useful tips to help you calculate COGS with confidence.
What COGS comprises — and why it's important
COGS contains only expenses tied to producing and purchasing the items that were sold. For a merchandiser, that is usually the cost to purchase inventory plus shipping and handling in. For a manufacturer, COGS is comprised of raw materials and direct labor and manufacturing overhead applied to goods sold. Indirect expenses — such as the general administrative payroll, marketing or rent on the corporate office — are excluded.
An accurate COGS figure has an impact on a companys gross profit or loss, its taxable income and the valuation of the inventory. When COGS is understated, gross profit and taxable income are overstated. If COGS is exaggerated, you could be underreporting profit and making bad pricing or purchasing decisions.
The standard cost of goods sold formula
The most common formula for calculating cost of goods sold is:
Opening Stock + Net Purchases - Closing Stock = Cost of Sales
This is a relevant equation for businesses that are purchasing finished goods for resale and many manufacturing business when adjusted for production. “Purchases (Net): Purchases includes purchase cost and freight-in, less any purchase returns or discounts netted.
Step-by-step COGS calculation example
Identify the "beginning inventory":
This is the worth of a company's inventory at the very beginning of an accounting period, according to its balance sheet. Example: $10,000.
Add net purchases for the period:
Purchases less returns and allowances plus freight-in. e.g. purchase $25,000; purchase returns $1,000; freight-in $500 → net purchases = $24,500.
Calculate goods available for sale:
beginning inventory + net purchases = $10,000 + $24,500 = $34,500.
Deduct ending inventory:
take a physical count or refer to your perpetual records to establish the value of goods left at the end of the period. Example ending inventory = $8,000.
plug in the numbers:
COGS = $34,500 – $8,000 = $26,500.
This is an example to find out how inventory value and purchase are flowing into cost of goods sold.
Inventory Systems, their effect on COGS
There are two types of inventory accounting methods: periodic and perpetual.
Perpetual inventory:
A physical count at the end of a period is taken to help establish ending inventory and COGS through the basic equation. This is typical for small retailers.”
Moving average inventory:
inventory and COGS reflect continuous updates as sales and purchases are made, with records of the quantity and cost per unit.
COGS is also influenced by the inventory methods of accounting – FIFO, LIFO and weighted average. Under FIFO (first-in, first-out), the older costs go to COGS. Under the LIFO (last-in, first-out) method, the latest costs go to COGS first. Weighted average smooths out cost changes by applying all costs of goods available for sale. The method used affects COGS and ending inventory amounts, even if the units movement is not altered.
Including manufacturing costs in COGS
For producers, COGS come from attributing the cost of production to products that are manufactured and sold. The manufacturing form of the formula, which is how most companies would use it, begins with beginning finished goods inventory and adds cost of goods manufactured (raw materials used plus direct labor plus manufacturing overhead applied), then subtracts ending finished goods inventory. The calculation of cost of goods manufactured itself takes into account corrections for the WIP inventory.
Per-unit COGS and pricing decisions
When you have total COGS, you can get per-unit COGS by dividing total COGS by the number of units sold during that time. Per-unit COGS is used to establish price and calculate your gross margin percentage. For example, if per unit is $15 and you want a 40% GM then $15 / (1 - margin) = $25 Thought dirty) getPrice So Margin-led pricing: Simple Target Price = Cogs/ 1- margin COGS/ 0.60 = target price
Common adjustments and considerations
Freight-in: Add the cost of getting the goods to your location to purchases.
Purchase returns and allowances: Deduct these when calculating net purchases.
Factory overhead: For and by Manufacturer [Allocate prospective, fixed/fixed type overhead where there is a logical driver (machine hours, labour hours etc.)].
Obsolete or damage inventory: Reduce inventory to NRV, which creates a write-down and either increases COGS or recorded as loss separately under accounting policy.
Inventory shrinkage: Ending inventory is drained by theft, breakage and unreported usage; this raises COGS; find shrinkage with periodic counts.
Journal entries and reporting
End-of-period adjusting entry In a periodic system, the end-of-period adjusting entry takes beginning inventory plus purchase minus ending inventory to COGS. In a periodic system, for each sale you'd debit inventory and credit COGS corresponding to the item sold.
How to make sure COGS is calculated correctly
Maintain readable, current records of purchase and freight.
Balance stock and ledger items on a consistent basis.
Select an inventory valuation method appropriate for your business and tax situation, and then use it consistently.
Separate direct costs of production from indirect overhead to prevent misclassification.
Apply unit costing to those products with significant variation in cost or use activity-based allocation for more complex overhead.
Common mistakes to avoid
- Excluding freight-in or purchase discounts from net purchases.
- Neglecting to consider returned goods or allowances in calculation of net purchases.
- The practice of applying different inventory valuation models throughout the periods, which confuses trend analysis.
- Blurring operating expenses and COGS—Only direct product costs should be in COGS.
Putting it into practice
To determine the COGS that you will claim for your next reporting period, you will need to obtain beginning inventory, all purchase invoices, freight and handling information and a dependable ending inventory valuation. Utilize COGS formula, inventory method and add assumptions. Review gross profit margin and compare to historical periods to identify discrepancies or errors in costing.
Conclusion
Understanding how to compute cost of goods sold is a valuable skill that enhances financial transparency. With correct COGS: You will have a clearer visibility to gross profit; you can make better decisions about pricing and purchasing, and report accurate financial statements. Whether you calculate your COGS using a basic period formula or a full-on manufacturing costing system, the key to accurate COGS calculation is due diligence and good record maintenance.