The cost of goods sold (COGS), also referred to as the cost of sales or cost of services, is how much it costs to produce your products or services. COGS include direct material and direct labor expenses that go into the production of each good or service that is sold.
For example, If you own a cookie company, examples of COGS would include the flour, sugar, chocolate chips (i.e. all the different ingredients), the boxes or bags and the direct labor used to make the cookies you sell. However, COGS does not include indirect expenses, like certain overhead costs. Do not factor things like utilities, marketing expenses, or shipping fees into the cost of goods sold.
How to Calculate Cost of Goods
To find the cost of goods sold during a certain period, use the COGS formula:
COGS = Beginning Inventory + Purchases During the Period – Ending Inventory
Your beginning inventory is the inventory is left over from the previous period. Next, add the cost of what you purchased during the period. Lastly, subtract whatever inventory you did not sell at the end of the period.
You can calculate for any time period; months, quarters, or calendar years.
As an example, Your business has a beginning inventory of $12,000, makes purchases valued at $7,000, and is left with an ending inventory of $6,000.
Use the COGS formula. COGS = $12,000 + $7,000 – $6,000
Why it Matters:
Cost of goods sold is the main and possibly the most important component in calculating gross profit, as it affects nearly every other profit measure. Calculating COGS is why most companies take inventory monthly.
Different inventory methods can generate different costs of goods sold for identical companies. It is important to first identify what inventory method a company is using before calculating. There are generally 3 types of methods.
FIFO – First In First Out
The earliest goods to be purchased or manufactured are sold first. Since prices tend to go up over time, a company that uses the FIFO method will sell its least expensive products first, which translates to a lower COGS than the COGS recorded under LIFO. Hence, the net income using the FIFO method increases over time.
LIFO – Last In First Out
The latest goods added to the inventory are sold first. During periods of rising prices, goods with higher costs are sold first, leading to a higher COGS amount. Over time, the net income tends to decrease.
Average Cost Method
The average price of all the goods in stock, regardless of purchase date, is used to value the goods sold. Taking the average product cost over a time period has a smoothing effect that prevents COGS from being highly impacted by extreme costs of one or more acquisitions or purchases.