Understanding Cost of Goods Sold (COGS)

June 7, 2024

Things we call Cost of Goods Sold (COGS), on the other hand, refer to the direct costs of creating the things your business sells. It’s what every piece of grass costs to make. That’s why, in the practical sphere of business, COGS is almost always calculated excluding things like the cost of your rent, salaries of your barristers and mowing equipment (or your intellectual property, if you’re a software company).

COGS is generally the cost of the direct inputs you need to transform to make your grass – it’s the cost of grass seeds, plot of land, farm hands and the equipment they use.

What's Included in COGS?

COGS encompasses various direct costs incurred in the production process:

• The cost of purchasing items for resale.
• Raw materials purchased to create products.
• Parts purchased for product assembly.
• Direct labor costs.
• Supplies used in production or sales.
• Manufacturing overhead costs like utilities.
• Direct shipping and freight charges.
• Direct container costs.

Formula for Calculating COGS

The formula for COGS is straightforward:

Beginning Inventory + Purchases - Ending Inventory = COGS

Example Calculation

Suppose your business begins the fiscal year with $100,000 of inventory. During the year, you incur $50,000 in purchase (inclusive of labor) expenses. Your residual inventory, then, is also $75,000.

Using the formula:
($100,000 + $50,000) - $75,000 = $75,000

So, your Cost of Goods Sold for the year would be $75,000.

If you are serious about running a business most profitably, COGS is one of the most important numbers you can compute. It gives you insights into how you spend money, how you price your goods, and ultimately how well your business performs.

Let's delve into three key reasons why calculating COGS is important for your business:

1. Your gross margins
2. Monitoring your inventory
3. Calculate your break-even point

Your COGS = Beginning Inventory + Purchases – Ending Inventory.

1. Understanding Profitability
   COGS is one of the main expenses in your profit and loss (P&L) statement that determines how much money your business is making or losing (just subtract COGS from your total revenue and this is your gross profit margin, or how much money you’re making after considering only the direct costs a business has to produce or purchase the goods they’re selling). Understanding this number will help you negotiate the prices you pay for your product and find a balance between customer service and your bottom line.

2. Effective Cost Management
   Knowing your COGS will inform you of the expenses your business directly incurs to produce its product. Tracking your COGS allows you to see if you are using inefficient employee productivity, paying higher prices for materials compared with others who produce the same goods, putting too many products in storage, or otherwise creating an expense that cuts into your bottom line. By mining your COGS to maximize your profit potential, you can save costs by negotiating lower material pricing or improving your production process.

3. Accurate Tax Reporting
   Businesses must file their COGS with the IRS, most commonly used for calculating taxable income. Accurate COGS reporting guarantees that you are paying the right amount of taxes, and allows you to take advantage of as many deductions as possible so that you can pay the least amount possible.

Cost of Goods Sold (COGS) data is important at many different points throughout the corporate operational cycle:

1. Planning Phase
   Used in conjunction with details about historic purchasing and operations, these accurate COGS data help managers to plan and execute efficient production, sales, and pricing strategies that lead to realistic financial projections and optimal use of resources.

2. Procurement and Production
   Aside from manufacturing costs, COGS also helps to understand the raw material purchases and production processes, so it supports controlling the costs, managing the inventory levels, and regulating production efficiency.

3. Sales and Revenue Generation
   COGS data is necessary for setting competitive prices, negotiating contracts and looking at the profitability of sales channels and product lines.

4. Financial Analysis and Reporting
   So having accurate data is an essential and continuous task throughout the operational cycle for financial reporting, analysis of performance and the evaluation of strategies to improve profitability and efficiency.

How to keep track of Cost of Goods Sold (COGS)?

1. Manual Records
   Keep detailed spreadsheets or accounting ledgers containing all of the direct costs of production such as materials, labor, and overhead.

2. Inventory Management Software
   Make use of inventory management software programs, which are often already equipped with features for tracking COGS, adjusting inventory levels, and creating reports.

3. Regular Inventory Audits
   Perform weekly actual inventory counts to match physical levels with those reported, identify discrepancies, and ensure that COGS calculations are based on correct information.

4. Costing Methods
   Use a consistent method to cost inventories. For example, First-In-First-Out (FIFO) or Last-In-First-Out (LIFO) is required for material purchases. These methods are used to allocate costs to the related inventory items so that the amount used in COGS calculations accurately reflects the value assigned to these items.

Indeed, at Britecheck, our team can get you all set up!

Want to know what kind of inventory solution makes the best sense for your business? Please get in touch with us and let us provide you with a suitable solution.