Cost of Goods Sold (COGS) Meaning
The Cost of Goods Sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company.
Understanding Cost of Goods Sold
Cost of Goods Sold is the cost that is directly related to the production of the goods sold in a company. In other words, COGS is the accumulation of the direct costs that went into the goods sold by your company. This amount includes the cost of any materials used in the production of the goods and also includes the direct labor costs used to produce the said well. Labor costs include direct labor and indirect laborIndirect LaborEmployees who are not directly involved in the production of finished goods or services are classified as indirect labour. They do, however, contribute to the production and manufacturing ecosystem. Accountants, human resources, sales and marketing teams, are it's examples.
- Costs of materials include direct costsDirect CostsDirect costs are costs incurred by an organization while performing its core business activity and can be attributed directly in the production cost, such as raw material costs, wages paid to factory staff, power & fuel expenses in a factory, and so on, but do not include indirect costs such as advertisement costs, administrative costs, etc. like raw materials, as well as supplies and indirect materials. Where non-incidental amounts of supplies are maintained, the taxpayer must keep inventories of the supplies for income tax purposes, charging them to expense or goods sold as used rather than as purchased.
- Direct labor costsDirect Labor CostsDirect labor costs refer to the total cost incurred by the company for paying the wages and other benefits to its employees against the task performed by them, which are straight away related to the manufacturing of the products or provision of the services. are the wages paid to those employees who spend all their time working directly on the product being manufactured. Indirect labor costs are the wages paid to other factory employees involved in the production. Costs of payroll taxes and fringe benefits are generally included in labor costs but may be treated as overhead costs.
- COGS excludes indirect expenses such as Sales Cost or Marketing costs. In the income statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements. presentation, the goods sold is subtracted from net revenues to arrive at the gross margin of a business.
- In the service industry, this would include payroll taxesPayroll TaxesPayroll taxes are statutory deductions made by the employer from an employee’s regular salary and wages, and usually, such withholdings mostly have both employer and employee equal contributions. These taxes are collected by tax authorities from respective employers and paid for human welfare schemes, infrastructure development., labor, and benefits for employees who are directly involved in providing the service. Any costs associated with indirect expensesIndirect ExpensesIndirect expenses are the general costs incurred for running business operations and management in any enterprise. In simple terms, when you want to buy grocery from a supermarket, the transportation cost to get you to the supermarket and back is the indirect expenses. are excluded from the COGS, such as marketing expenses, overhead, and shipping fees.
- For example, of the cost for a Laptop, the maker would include the costs of material required for the parts of the Laptop plus the labor costs used to assemble the parts of the Laptop. The cost of sending the laptops to dealers and the cost of the labor incurred to sell the laptops would be excluded. Also, costs incurred on the laptops that are in stock during the year will not be included when calculating the Cost of Goods sold, whether the costs are direct or indirect. In other words, These include the direct cost of producing goods or services that are sold to the customers during the year.
Cost of Goods Sold Formula
Cost of Good Sold Formula = Beginning Inventory + Purchases – Ending Inventory.
- Beginning Inventory: – inventory at the start of the year; This should be exactly the same as your ending inventoryEnding InventoryThe ending inventory formula computes the total value of finished products remaining in stock at the end of an accounting period for sale. It is evaluated by deducting the cost of goods sold from the total of beginning inventory and purchases. from last year.
- Purchases(Additional Inventory): – inventory that you purchased during the year;
- Ending Inventory: – inventory at the end of the year;
Let us calculate COGS using the above formula
Inventory recorded at the beginning of the fiscal year ended in 2017 is $2000. Additional Inventory: Inventory purchased during the fiscal year 2017-18 is $1500. Ending Inventory: Inventory recorded at the end of the fiscal year ended 2018 are $1000
- As per the cost of goods sold formula, COGS is = 2000 + 1500 -1000 =$2500
- Therefore, $2,500 is the cost of goods sold.
Extended COGS Formula
Below is the COGS Formula extended to include returns, discounts, allowances and freight charges
COGS = Starting Inventory + Purchases – Purchase Returns & Allowances – Purchase Discounts + Freight In – Ending Inventory
- Starting Inventory: Opening stockOpening StockOpening Stock is the initial quantity of goods held by an organization during the start of any financial year or accounting period. It is equal to the previous accounting period's closing stock, valued in accordance with appropriate accounting standards based on the nature of the business. for the period;
- Purchases: Any purchase made for manufacture / setting up the product (e.g., raw material)
- Purchase Returns & Allowances: (a) Purchase Returns include items that are returned to suppliers (if any) (b) Allowances include any additional benefit received in the purchase chain for the product
- Purchase Discounts: Discounts received in the supply chain; reducing it from costs as this is accountable for the increase in profits
- Freight In: Transportation costs for the product raw materials to be brought to factory (or set up location)
- Ending Inventory: Closing stock for the periodClosing Stock For The PeriodClosing stock or inventory is the amount that a company still has on its hand at the end of a financial period. It may include products getting processed or are produced but not sold. Raw materials, work in progress, and final goods are all included on a broad level..
Calculate Cost of Goods Sold
Consider a basic example of Company ABC manufacturing a packet of pens. The direct costDirect CostDirect costs are costs incurred by an organization while performing its core business activity and can be attributed directly in the production cost, such as raw material costs, wages paid to factory staff, power & fuel expenses in a factory, and so on, but do not include indirect costs such as advertisement costs, administrative costs, etc. of manufacturing is $1.00 / packet. Below are statistics
- Opening Inventory as on 01/01/2017: 3500 packets
- Closing Inventory as on 12/31/2017: 500 packets
- Costs incurredCosts IncurredIncurred Cost refers to an expense that a Company needs to pay in exchange for the usage of a service, product, or asset. This might include direct, indirect, production, operating, & distribution charges incurred for business operations. during the year are as under:
- Purchase cost: $100,000
- Discounts received: $5,000
- Freight In: $25,000
Cost of opening Inventory: 3500 packets x $1.00 = $3500.00
Cost of closing inventory: 500 packets x $1.00 = $500.00
Hence, the calculation of Cost of Goods Sold is
- COGS = $3,500 + $100,000 – $5,000 + $25,000 – $500
- COGS = $123,000
Now consider an example of 2 products manufactured by a company. Below are statistics for Product X and Product Y:
For Product X-
- Opening Inventory: 5000
- Closing Inventory: 1500
- Cost per unit: $5.00
- Cost of materials: $120,000
- Cost of labor: $500,000
- Freight In: $40,000
For Product Y-
- Opening Inventory: 10,000
- Closing Inventory: 7,500
- Cost per unit: $2.00
- Cost of materials: $80,000
- Cost of labor: $300,000
- Freight In: $25,000
- Discount received: $5,000
Apart from the above direct costs, the manufacturing unit has the below overhead costs:
- Annual rent of manufacturing unit: $50,000
- Annual electricity charges: $75,000
- Salary of the supervisor: $70,000
For individual products, total direct cost is as below:
For Product X –
- Cost of opening inventory: 5000 X $5.00 = $25,000
- Cost of closing inventory: 1500 X $5.00 = $75,000
- Direct cost = $120,000 + $500,000 + $40,000 = $660,000
As COGS is calculated using only direct costs, we should ignore the indirect costsIndirect CostsIndirect cost is the cost that cannot be directly attributed to the production. These are the necessary expenditures and can be fixed or variable in nature like the office expenses, administration, sales promotion expense, etc. related to these products. So the calculation of Cost of Goods Sold using COGS formula is as below.
- COGS = $25,000 + $660,000 – $75,000
- COGS = $610,000
For Product Y –
- Cost of opening inventory: 10,000 X $2.00 = $20,000
- Cost of closing inventory: 7,500 X $2.00 = $15,000
- Direct cost = $80,000 + $300,000 + $25,000 – $5,000 = $400,000
As COGS is calculated using only direct costs, we should ignore the indirect costs related to these products. So the calculation of Cost of Goods Sold using COGS formula is as below
- COGS = $20,000 + $400,000 – $15,000
- COGS = $405,000
Consider an example of the service industry – a courier firm. For a courier firm, the basic service is to route packets from their customers to appropriate destinations. This activity includes different types of costs. Consider, company XYZ is a courier firm, which picks up consignments from their customers and then connects it further for the right delivery. Below are statisticsStatisticsStatistics is the science behind identifying, collecting, organizing and summarizing, analyzing, interpreting, and finally, presenting such data, either qualitative or quantitative, which helps make better and effective decisions with relevance. for the year 2017.
- Pick up cost: $200,000
- Packing Material: $50,000
- Re-routing cost: $1,500,000
- Labour: $100,000
There may be other costs involved like traveling, administrative, selling and marketing, etc. However, these are not included as they are indirect expensesIndirect ExpensesIndirect expenses are the general costs incurred for running business operations and management in any enterprise. In simple terms, when you want to buy grocery from a supermarket, the transportation cost to get you to the supermarket and back is the indirect expenses..
So, the calculation of Cost of Goods Sold will be –
- COGS = $200,000 + $50,000 + $1,500,000 + $100,000
- COGS = $1,850,000
Impact of Inventory Method on COGS
It can also be impacted by the type of costing methodology used to derive the cost of ending inventoryEnding InventoryThe ending inventory formula computes the total value of finished products remaining in stock at the end of an accounting period for sale. It is evaluated by deducting the cost of goods sold from the total of beginning inventory and purchases.. There are one of three methods of recording the cost of inventory during a period – First In, First Out (FIFO), Last In, First Out (LIFO), and Average Cost Method.
Consider the impact of the following inventory costing methods:
- First in, first-out method – Under this method, known as FIFO Inventory, the first unit added to the COGS inventory is assumed to be the first one used. In an inflationary environment, where prices are increasing, FIFO results in the charging of lower-cost goods to the COGS.
- Last in, first-out method – Under this method, known as the LIFO Inventory, the last unit added to the cost of goods sold inventory is assumed to be the first one used. In an inflationary environment where prices are increasing, LIFO results in the charging of higher-cost goods to the cost.
- Average Cost Method – The average cost is calculated by dividing the total cost of goods ready for sale by the total number of units ready for sale. It gives a weighted-average unit cost that is applied to the units available in closing inventory at the end of the period.
Cost of Goods Sold Video
This article has been a guide to the Cost of Goods Sold (COGS) and its definition. Here we discuss how to calculate COGS using basic and extended formulas. You may also have a look at these articles below to learn more about Accounting –