Definition, examples, how to calculate, why it's important

Table of Contents

What are COGS?

Examples of COGS?

Why are COGS Important?

Formula and Calculation of Cost of Goods Sold

Purpose of Cost of Goods Sold

Limitations of COGS


What are COGS?

The dictionary definition of COGS is the total cost incurred in the production and delivery of a product or service. Production and delivery can mean different things in different businesses, for example a SaaS company would consider hosting costs that support their website and cloud applications a COGS expense because they simply could not deliver their product without that paying that cost.

A retail clothing retail company on the other hand would include expenses such as raw materials, production, and shipping as COGS, but they would not consider their website hosting as COGS because they technically do not need the website to produce and deliver the goods. The website would likely be classified as a sales and marketing expense, which like other operations and overhead costs, would be excluded from COGS.

Examples of COGS?

Expenses that are included in COGS differ primarily based on what type of product or service the company provides, and the largest differences are between physical and digital goods. Below you'll find some examples for each bucket:

Physical Goods (eCommerce, Manufacturing, Brick & Mortar Stores):
  • Raw materials
  • Warehousing & Storage
  • Pick & Packing (assembly, boxes, wrapping)
  • Shipping & Fulfillment
  • Returns Processing
Digital Goods (SaaS, Mobile App, Online Courses, Marketplace):
  • Application Hosting & Monitoring
  • Data Communications
  • Embedded SaaS Licenses
  • Customer Success
  • Professional Services

Why are COGS Important?

COGS are important for many reasons and many of them have to do with the fact that COGS are used to calculate Gross Margin. The calculation for Gross Margin is simple in that it's simply Revenues - COGS, and it is often expressed as a percentage (i.e. 70% Gross Margin). This is an important metric that many investors and business leaders focus on because it's one of the principal measures of a company's profitability.

Formula and Calculation of Cost of Goods Sold

Understanding how to calculate the Cost of Goods Sold (COGS) is critical for any business. The COGS calculation is very simple: Subtract the value of unsold products from total sales revenue. Simply put, COGS is the cost of inventory sold during a specific time period. The formula for calculating COGS is as follows: 

COGS = Beginning Inventory + Period Purchases – Period Ending Inventory. 

The value of inventory at the start of the period is known as "Beginning Inventory," while the cost of inventory acquired during the period is known as "Purchases During the Period." Finally, "Ending Inventory" refers to the value of inventory at the end of the term.

Calculating COGS entails determining the cost of products sold for a particular period. This comprises direct labor, direct materials, and other direct costs related to the manufacture of the commodities sold. Direct expenses for manufacturing enterprises include raw materials, direct labor, and overhead expenses such as rent and energy. "Direct costs" in a retail business relate to the money spent on the actual inventory sold. Once you've calculated these expenses, subtract them from the total cost of the items sold to get the COGS.

Although COGS do not include general or administrative costs like as salaries or wages, certain labor costs can be included. For example, if a company relies on independent contractors to generate income, any commission paid to these contractors may be included in COGS because this labor expense is directly related to the revenue generated. It's crucial to understand that COGS is determined by dividing the total amount of goods sold by the cost of goods sold.

Inventory is an important factor in calculating COGS. COGS will, in principle, have included the cost of all the inventory sold for that period. In practice, however, companies may not be aware of which precise units of commodities were acquired and sold. Businesses utilize accounting methods such as the first-in, first-out (FIFO), and last-in, first-out (LIFO) principles to identify the value of inventory that was actually sold during the period. If the value of the company's inventory included in COGS is much higher than the average, the company's gross profit may suffer as a result, in order to improve the amount of profit reported, companies may use accounting practices that result in a lower COGS figure.

COGS is an important measure for any company. It enables businesses to determine the cost of products sold during a specific time period, which is critical for calculating the company's gross profit. When determining COGS, all direct expenses involved with the production of the goods being sold, as well as any labor costs directly tied to revenue, must be considered. Furthermore, organizations must properly manage their inventory in order to compute COGS accurately, as errors can lead to erroneous reporting. Businesses can make more informed decisions about their finances and operations by knowing the purpose and limitations of COGS.

Purpose of Cost of Goods Sold

The Cost of Goods Sold (COGS) is a method that assists organizations in determining the amount of money that is actually required to create and sell the goods and services they offer. When determining a company's gross profit margin, one of the most important measures that are taken into consideration is the cost of goods sold, often known as the COGS. After deducting the cost of goods sold from a company's total revenue, one can arrive at this margin. When attempting to ascertain whether or not a company is able to generate profits from the operations that comprise its principal business, investors and analysts should look first and foremost to the gross profit margin as the most important metric to employ.

When determining a company's net income, it is also crucial to take into account the company's COGS. After all other expenses have been deducted from a company's revenue, the remaining revenue is what is used to compute the net profit for a business. If a company keeps track of its cost of goods sold, it will be able to evaluate how effectively it is able to keep its costs under control and how effectively it is producing the items or services it offers.

Limitations of COGS

Even though COGS is a significant statistic for determining how well a company is doing financially, the method is not without its flaws. The fact that COGS only accounts for direct expenses linked with the production of goods or services is a significant limitation that must be taken into consideration. It does not include other indirect expenditures, such as marketing expenses or costs associated with research and development, all of which are essential to the success of a company.

In addition, COGS is helpful in determining the overall financial success of a business only if the business deals in the sale of tangible products. COGS is not applicable to service-based organizations because these types of companies do not carry any kind of physical inventory. In addition, when determining COGS, it is assumed that the cost of inventory would be the same during the entirety of the time. Due to the fact that the cost of raw materials and other inputs is subject to change, this is not true in every circumstance.


How Do You Calculate the Cost of Goods Sold (COGS)?

To determine a company's cost of goods sold (COGS), you must first add the cost of goods that were already in inventory at the beginning of a specific period to the cost of goods that were purchased during that period by the company and then you must subtract the cost of goods that were still in inventory at the end of that period.

The formula that can be used to determine COGS is as follows, as was indicated earlier in this discussion:

COGS is calculated by subtracting the beginning inventory from the ending inventory and adding the purchases made during the period.

How Does Inventory Affect COGS?

Because it is factored into the calculation, inventory might have an effect on COGS. The cost of the inventory that has been sold during the accounting period is used to calculate the cost of the items that have been sold. In the event that the cost of inventory goes up, the cost of the goods that are sold will also go up. On the other hand, if there is a reduction in the cost of inventory, there will be a corresponding reduction in the cost of products sold.

It is necessary for any organization, no matter the size, to have a solid understanding of COGS, whether it be a small startup or a major conglomerate. Businesses are able to establish their profitability, locate areas in which they may make improvements, and make educated decisions regarding pricing, manufacturing, and inventory management when they keep track of their COGS. Even though it has several drawbacks, the cost of goods sold continues to be an important financial statistic that can assist companies in achieving their objectives and remaining competitive in their individual markets.

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