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Definition: COGS (Cost of Goods Sold)
It is the total cost attributable to the goods that have been sold during the year or in the accounting period. It includes the purchase cost of raw materials, cost of conversion of raw material into finished goods, labour, freight and other costs incurred to bring it to the condition of sale. In case of finished goods, i.e. in trading business, COGS includes the purchase cost, freight and other inventory related costs to bring the goods to present condition and location.
It can be accounted in 3 ways:
FIFO: First in first out
LIFO: Last in first out
It is used to find out the gross profit. I.e. sales (-) COGS.
COGS excludes indirect cost such as:
• Distribution cost
• Sales representative and sales team
The factors included in COGS differ for different business. For a manufacturing firm, COGS will include cost of raw material, direct labour and infrastructure expenses like electricity and water. For a retail shop, COGS consist of cost of finished goods procured from manufacturer and cost of staff employed etc.
In a firm’s income statement, COGS is deducted from revenues to arrive at the Gross Margin of the firm.
Gross Margin = Revenues - COGS
Types of Inventory Management System
1. Periodic Inventory System
In this system, COGS is calculated using the below formula:
COGS= Beginning Inventory+ New Purchases – Ending Inventory
The above equation gives the amount of goods that has been moved out of the warehouse in the given period. The drawback of this method is that COGS which is calculated also reflects the goods which are misplaced, stolen or obsolete, thereby leading to error in the calculation.
2. Perpetual Inventory System
In this system, COGS is record and updated under various heads such as Inventory received, Goods sold, Goods scrapped and Goods moved another warehouse.
This system gives a clear picture on the movement of goods thereby leading to better reporting in terms of accuracy.
Types of Inventory costing system
COGS is influenced by the type of cost methodology adopted by the firm. Let us look at the four methods briefly
1. First in, First out (FIFO)
This system replicates the actual purchasing cycle. Under FIFO methodology the cost associated with oldest unit are assigned to inventory sold irrespective whether the units where procured at that cost or some other cost. It assumes that the first inventory in is the first inventory out and so on.
For example, if company A buys 10 computers at $100 each and then buys 10 more at $110 each, then the company assigns $100 for first 10 computers sold and $110 for the next 10 computers.
2. Last in, first out (LIFO)
This system is polar opposite to the FIFO method in which the cost of the last unit procured is assigned to the first unit sold. This method is generally applied by producer in bulk items like coal, gravel yard etc. where stacking of goods happens in bulk quantity.
For example, if company A buys 10 tons of coal at $100 per ton and then buys 9 tons of coal at $110 per ton, then the company assigns initially coal at $110 per ton for 9 tons and $100 for the next 10 tons of coal.
3. Weighted Average Cost
In this method the cost is assigned to the goods by calculating the moving average cost of all purchases. This method provides an accurate cost of goods sold and hence is preferred by a lot of firms.
For example, if we consider the example given above the average cost of computer would work out to be $9.50
4. Specific Identification Method
In this method the specific product is identified and the cost is assigned to the specific item. This is method is highly suited for low volume and high value product as it is easy to track.