Cost of Goods Sold (COGS) Definition, Importance, Example, Types, Formula & Overview

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Definition: Cost of Goods Sold (COGS)

Cost of Goods Sold (COGS) or Cost of sales is the sum total of all the direct costs incurred in the production of any product and the inventory of the company. Cost of sales is popularly known as ‘Cost of goods sold’ (COGS) and is a globally used term for preparing the income statement of companies.

For the products COGS is the cost of raw material and cost of labor involved directly in the production, together known as the direct costs. Expenses such as marketing expenses, rent, electricity supplies, administration expenses and salary to all the factory or firm employees all come under the indirect costs or the overhead costs and do not account for the cost of sales. COGS 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.

Importance of Cost of Goods Sold (COGS)

Cost of Goods Sold (COGS) is a metric to analyze the costs involved in the production. For example if the revenue generated is constant while the cost of sales is rising then it might be an instance to revise the schedule of production and see where the costs have risen. However there is fundamentally no difference between ‘Cost of sales’ and ‘Cost of goods sold’ but the former is generally used by the retailers of any product while the latter is used by the direct producers. There are various costs incurred by the producer in the production of any product such as cost of raw materials, cost of labor involved, rent of the facility, electricity expenses and costs related to other resources. These costs are generally divided into two categories namely ‘Direct’ costs and ‘Indirect’ costs.

Cost of Goods Sold (COGS)

In the service based industries, it is difficult to trace the direct costs involved in the production or delivery of any service and hence cost of sales is seldom used to denote the costs involved in a service for example doctors, advisory firms, consultancies and alike. For hybrid firms or firms which offer a combination of products and services both to their customers can however include the cost of sales to denote any direct costs. For example hotel industry, airline industry and alike.

Cost of Goods Sold Formula (COGS)

Before calculating the cost of sales or cost of goods sold it is imperative to be familiar with these terms:

Beginning/opening/initial inventory: Cost of whatever items left over from the previous financial period,

Closing/ending inventory: Cost of inventory a company has in stock at the end of its financial period

Formula for cost of sales or cost of goods sold (COGS):

[Opening inventory + additional inventory – closing inventory]

Example of Cost of Goods Sold (COGS)

XYZ manufacturer has an opening inventory of worth INR 10000. They produce additional goods of worth INR 5000 and at the end of their financial period; they have a closing inventory of worth INR 2000.

Now its cost of sales or COGS will be INR (10000+5000-2000) which equals to INR 13000.

Cost of sales can be used to calculate the gross profit or loss for a company and its products. For example in the same company XYZ manufacturer, revenue generated is INR 20000 while their cost of sales is INR 13000. Hence their gross profit will be INR (20000-13000) which equals to INR 7000. This metric gives a tentative idea of the direction in which the costs of production are headed as compared to the revenue it generates.

Cost of goods sold can be accounted in 3 ways:

1. FIFO: First in first out

2. LIFO: Last in first out

3. Weighted average.

It is used to find out the gross profit. i.e. difference between sales & COGS.

COGS excludes indirect cost such as:

1. Distribution cost

2. 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

COGS based on Types of Inventory Management Systems

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.

COGS based on 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. This gives an overview of cost of goods sold valuation based on inventory costing systems.

Hence, this concludes the definition of Cost of Goods Sold (COGS) along with its overview.

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