Is your company making profits? If yes, how much? You can not answer these questions if you have no idea about COGS.
Many businesses find it challenging to manage their expenses effectively, which can hurt their profits. That’s why it is super important to understand these expenses. Cost of Goods Sold (COGS) is an expense. COGS includes all the direct costs involved in producing or buying the products a company sells, such as materials and labor.
For example, if you run a bakery, COGS would include the cost of flour, sugar, eggs, and any other ingredients used to bake the bread or cakes you sell and the wages of the bakers who make them.
What is COGS?
COGS stands for Costs of Goods Sold. It is the direct costs associated with a company's products or services. These costs include raw materials, packaging, direct labor, and manufacturing overhead.
For the manufacturer, COGS is an expense related to producing the product. It includes the cost of raw materials and wages directly involved in production for factory workers.
For a retailer, it is the purchase price of the inventory sold. Note that COGS does not include indirect costs such as administrative salaries, marketing expenses, or rent for office space, as these are counted under operating expenses.
Example Of COGS
As you already know, not all costs can be included in CGS. The best idea to determine whether the expense is COGS is to ask if this cost exists if no products were made. If you get NO as an answer, it’s most probably a COGS expense.
Common examples of COGS include:
- Items bought for resale
- Purchase returns and allowances
- Raw materials
- Freight in charges or shipping costs
- Discount
- Factory labor
- Overhead costs
- Storage expenses
Why is COGS an Important Financial Metric?
Here is why you should understand and track your COGS.
Gross profit calculation:
COGS helps determine gross profit, the money left after subtracting COGS from total sales. Additionally, gross profit shows how efficient a business is in making products.
The formula to find out gross profit: Gross Profit = Revenue - COGS
Higher gross profit means better control over production costs.
Pricing Strategies
Knowing your COGS will help you set the price of your products correctly. Thus, you will not only understand production costs that cover expenses and make a profit but also refrain from overpricing and losing customers.
Budgeting and Forecasting
Accurate COGS data allows businesses to predict future costs and set realistic budgets. This helps maintain profitability and plan for growth.
Tax Benefits
Note that COGS is a tax-deductible expense. Therefore, if you calculate it correctly, it can lower taxable income and lead to tax savings as long as you follow tax rules and regulations.
What are the Key Components of COGS?
Here are the components of COGS, so you can better understand how it is calculated and make the right decisions for your business.
Raw Materials
The first component of COGS is raw materials. These are the basic materials used to produce your products or services. Depending on your industry, this includes things like wood, fabric, or metal. Tracking and managing your raw material costs is essential to maximizing efficiency and minimizing waste.
Packaging
The second component is packaging. This includes the materials used to package and protect your products, such as boxes, bags, or labels. Moreover, packaging costs can vary depending on the size, shape, and materials used for your products.
Direct Labor
Next, we have direct labor. This refers to the wages or salaries paid to the employees directly involved in the production process. It includes the workers who assemble, manufacture, or provide services related to your products.
Manufacturing Overhead
Manufacturing overhead includes all indirect costs associated with production that cannot be directly attributed to a specific product. It also includes expenses like rent, utilities, equipment maintenance, and production supplies.
How To Calculate COGS?
Here’s how to calculate your COGS (Cost of Goods Sold):
- Start with Beginning Inventory: This is the value of the inventory you have at the start of the period.
- Add Purchases: Include the cost of any additional inventory or raw materials you bought during the period.
- Calculate Total Goods Available for Sale: Add the beginning inventory and the purchases together.
- Subtract Ending Inventory: This is the value of the inventory you have at the end of the period.
COGS Formula:
COGS = Beginning Inventory + Purchases − Ending Inventory.
This formula gives you the total cost of the goods you sold during the period.
Some Accounting Methods For COGS
There are three common accounting methods for calculating COGS:
- FIFO (First In, First Out): In this method, the oldest inventory items are sold first. It means the cost of goods sold is based on the price of the earliest purchases.
- LIFO (Last In, First Out): Here, the most recently purchased items are sold first, so COGS is based on the cost of the latest purchases.
- Average Cost: This method calculates COGS by averaging the cost of all inventory items. Hence, it provides a middle ground between FIFO and LIFO.
Each method affects your profit and taxes differently.
COGS (Cost of Goods Sold) is a crucial part of any business that buys products to manufacture or resell. It needs to accurately reflect the actual costs of producing your product so you can set the right prices. COGS is also important when filing your taxes. Besides, banks and investors pay close attention to your COGS. Therefore, you must know how to calculate it to make smart business choices.
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