What is COGS (Cost of Goods Sold)?
Cost of Goods Sold (COGS) is the term used to describe the direct costs of manufacturing a product. It includes the costs of the materials, storage and manufacturing labour, but not indirect costs such as distribution, marketing and management salaries.
COGS is considered a business expense and impacts your profit — the higher your COGS, the lower your profit margin. Financial and income statements usually list COGS according to the accounting period they cover.
Cost of Goods Sold vs. Cost of Sales
Not all businesses calculate COGS — some companies refer to cost of sales instead. Your business type determines the type of costs you'll incur.
Companies that sell tangible products, like t-shirts, building materials or food, will calculate the cost of goods sold. Companies that sell services, such as accounting firms, lawyers or consultants tend to calculate the cost of sales as they don’t sell goods. However, the requirements for calculating this are the same.
Both types of companies must report the “cost of goods sold” or the “cost of sales” in their financial statements.
What does COGS include?
Your industry and product type determine what you include in COGS calculations. For example, an ecommerce store may consider the cost of wholesale products, inventory storage and website expenses when determining COGS. A restaurant, on the other hand, calculates COGS using food, labour and overhead costs.
Here are some of the most common COGS items:
Materials, such as products or parts needed to assemble products, or items purchased for resale.
Labour, including shipping parts to the warehouse and salaries for production workers.
Operations costs, like depreciation of hardware and software that support production, as well as factory overheads.
There are two distinct categories of Cost of Goods Sold:
Direct costs
Direct costs are those directly linked to the making of a product, including freight-in costs, cost of materials and labour costs.
Indirect costs
Indirect costs support product production more broadly, such as factory overheads, storage costs and the cost of using equipment (depreciation).
The importance of COGS for businesses
Understand your financial health
Identifying your COGS is essential to assessing your company's financial health. If you want to be successful, you have to be profitable, and you can only calculate gross profit margins if you know what you spend on producing each item.
Make strategic business decisions
Keeping up-to-date on your COGS can help you make better business decisions. For example, if your COGS increases, you might consider reducing production costs or raising your prices to maintain profitability.
Implement accurate pricing
Your business may generate a lot of revenue, but if your COGS is too high, you won't make much profit. Calculating your COGS gives you valuable insight into how much you’re spending on your inventory so you can adjust your pricing accordingly.
Attract investment opportunities
COGS is a significant business expense that affects your bottom line. Thus, investors consider it when deciding whether to invest in you (and how much to invest). Knowing your COGS helps lenders and investors accurately assess your business's potential and profitability.
COGS accounting methods
Calculating COGS requires choosing an appropriate inventory valuation method. Your tax agent or accountant should advise you on the valuation method to use for your business. Here are some of the most commonly used methods:
First In, First Out (FIFO)
The FIFO method sells the oldest inventory first. As prices increase over time, the least expensive products get sold first, leading to a lower initial COGS.
Weighted Average Cost (WAC)
The WAC method calculates a weighted average cost based on COGS and inventory spending. To determine WAC, divide the cost of goods purchased by the total number of units to get the average cost per unit.
Special Consideration Method
The special consideration method calculates ending inventory and COGS by analysing each unit's cost. This method relies on knowing the specific items sold and their exact prices, which can be difficult if you have a diverse product catalogue. As such, companies that sell big-ticket items like expensive jewellery, cars and houses usually use this method.
How to calculate COGS
Once you've determined your valuation method, you must prepare some information before calculating COGS.
First, decide which period your calculation will cover. Most businesses calculate COGS over an annual period for tax purposes.
Then, you’ll need to know your beginning and ending inventory figures. Your beginning inventory is the value of the inventory you still have from the previous accounting period, while your ending inventory is the value of the inventory that remains at the end of the current period.
It's also important to know how much your costs were during the period. These expenses include both direct and indirect costs, as explained earlier.
Once you have your numbers, calculating COGS is as simple as plugging them into the COGS formula:
(Beginning inventory + Purchases) – Ending inventory = COGS
Add the value of your beginning inventory and the total purchases/expenses during the accounting period. Lastly, subtract the ending inventory value.
Example of calculating COGS
Let's look at the cost of goods sold for a hypothetical company. For example, let’s say ABC Footwear Brand is measuring its inventory for the first quarter.
The company’s inventory value was $45,000 at the start of the quarter. The company’s purchases and other COGS-related expenses during the quarter totalled $25,000, and they ended the quarter with $10,000 worth of inventory.
Using the COGS formula, we can calculate the ABC Footwear Brand’s COGS as follows:
($45,000 + $25,000) – $10,000 = $60,000
Track your COGS with MYOB
With MYOB’s business management platform, you can seamlessly connect inventory management software to your accounting system. This means you can seamlessly keep track of your inventory expenses and have the data to calculate your cost of goods sold and generate accurate financial statements.
MYOB brings together all the key workflows that you need to run your business. With integrated software to help you manage your suppliers, customers, employees, projects, finance, accounting and tax, MYOB has you covered. Cloud-based, you pay for the features and functionality you need today, but have the ability to scale your software to meet tomorrow’s needs.
Check out our plans and pricing and get started with MYOB today!
Disclaimer: Information provided in this article is of a general nature and does not consider your personal situation. It does not constitute legal, financial, or other professional advice and should not be relied upon as a statement of law, policy or advice. You should consider whether this information is appropriate to your needs and, if necessary, seek independent advice. This information is only accurate at the time of publication. Although every effort has been made to verify the accuracy of the information contained on this webpage, MYOB disclaims, to the extent permitted by law, all liability for the information contained on this webpage or any loss or damage suffered by any person directly or indirectly through relying on this information.
MYOB is not a registered entity pursuant to the Tax Administration Act 1994 and therefore cannot provide taxation advice to clients. If you have a query concerning taxation including filing your GST returns or annual tax statements, then you should consult with your accountant or other registered tax adviser.