Cost of Goods Sold: Definition and Calculation
Cost of Goods Sold (COGS) is your direct cost during acquisition or production. Learn how to calculate it, what costs are included, and why it’s essential for business profitability.
What does Cost of Goods Sold mean?
Cost of Goods Sold, often abbreviated to COGS, refers to the direct costs a business incurs to produce or acquire the products it sells during a specific period.
It includes expenses such as raw materials, manufacturing supplies, labor directly involved in production, and any other costs necessary to get the product ready for sale. Essentially, COGS represents the “cost” of the inventory that was actually sold, not the inventory that remains unsold.
Understanding COGS is crucial because it directly affects a business’s gross profit. Gross profit is calculated by subtracting COGS from total revenue, so higher costs of production will reduce the profit margin, while lower costs increase it.
Accurately calculating COGS also ensures that financial statements reflect the true profitability of a company and helps in making informed pricing, budgeting, and inventory management decisions.
COGS is typically recorded on the income statement and varies depending on the type of business and accounting method used.
For example, a retailer will include the cost of purchasing goods from suppliers, whereas a manufacturer will include materials, labor, and overhead associated with production.
Tracking COGS accurately is essential for tax purposes, as it is subtracted from revenue to determine taxable income.
How to Calculate the Cost of Goods Sold
The Cost of Goods Sold (COGS) is calculated by taking the value of your beginning inventory, adding the cost of any additional purchases or production during the period, and then subtracting the ending inventory.
Cost of Goods Sold Formula
COGS = Beginning Inventory + Purchases (or Production Costs) – Ending Inventory
For example, if a business starts the month with $10,000 worth of inventory, buys an additional $5,000 in materials, and ends the month with $4,000 in inventory, the COGS would be $10,000 + $5,000 – $4,000, which equals $11,000.
What is included in the Cost of Goods Sold?
COGS includes all the direct costs that are necessary to produce or acquire the products a business sells. This typically covers the cost of raw materials used to make the product, the labor directly involved in manufacturing or assembling it, and any other production expenses such as utilities for the factory or manufacturing supplies.
For businesses that purchase products for resale, COGS includes the purchase price of the goods, shipping or delivery fees, and any import duties or taxes directly tied to acquiring the inventory.
COGS does not include indirect expenses such as marketing, sales commissions, administrative salaries, or rent for office space, since these costs are not directly tied to producing or purchasing the goods.
By including only the direct costs associated with creating or acquiring products, COGS provides a clear picture of the actual expense incurred to generate the revenue from sold goods, which is essential for calculating gross profit and assessing profitability.
