Cost of Goods Sold (COGS) is a commonly used term in the world of business, accounting, and finance. It refers to all costs incurred by a company in the process of producing and selling goods or services. COGS plays a critical role in determining a company’s profit or loss.
COGS is part of a company’s production costs and is used to calculate profit or loss by comparing various related expenses, such as raw materials, employee wages, marketing costs, and other expenses involved in production and sales. By properly understanding and managing COGS, a business can optimize profitability and make more informed decisions when running its operations.
Definitions of COGS by Experts
Experts offer various perspectives on COGS:
- According to Bustami and Nurlela, COGS consists of production costs that include raw materials, direct labor, and factory overhead, minus opening inventory and plus closing inventory. They state that COGS is tied to a specific period and will equal production costs when there is no inventory at the beginning or end of the period.
- Mulyadi defines COGS as the production costs of goods or services within a given period, from the start of production until the goods or services are ready for sale.
- Raiborn and Kinney describe COGS as the total production cost of goods that have been completed and moved into finished goods inventory during a particular period.
Why is COGS Important? Some Key Reasons:
- Setting Selling Prices: COGS is a key factor in determining a product’s selling price. Knowing production costs allows businesses to price their products for profitability.
- Understanding Gross Margin: Calculating COGS helps businesses measure gross profit per unit sold, which forms the basis for calculating net profit.
- Measuring Production Efficiency: The total COGS affects how much needs to be produced to hit profit targets. High COGS may indicate excessive production spending.
Components of COGS
COGS includes several essential components used in the calculation, such as:
- Beginning Inventory: This is the value of unsold inventory at the start of the accounting period. It includes leftover goods from the previous cycle.
- Ending Inventory: This is the value of remaining goods at the end of the accounting period after adjustments. It reflects unsold stock still in storage.
- Net Purchases: This is the total value of goods purchased during a given period, including shipping costs, minus any returns and discounts. It represents the actual volume of goods acquired.
- Net Sales: This is the actual revenue from sales after returns, discounts, and allowances have been deducted. It reflects the real earnings from selling the company’s products or services.
Methods of Calculating COGS
There are several methods companies can use to determine their COGS value, depending on their accounting approach. Here are three common methods:
1. First In First Out (FIFO)
FIFO assumes that the earliest inventory acquired is the first to be sold. In other words, goods purchased or produced first are sold first. This means the inventory left at the end of the period is assumed to be the most recently produced.
When the cost of raw materials or labor rises during a period, FIFO typically results in a higher inventory valuation for remaining goods, which can lead to a lower reported COGS.
2. Last In First Out (LIFO)
LIFO assumes the most recently acquired inventory is sold first. Goods purchased or produced last are sold first, while the oldest inventory remains at the end of the period.
If production costs increase, LIFO results in lower inventory valuations for remaining stock, which may lead to a higher COGS.
3. Weighted Average Method
The weighted average method calculates inventory values using the average cost of all goods purchased or produced during the period. It evens out price fluctuations by combining costs throughout the cycle.
The total cost of production is divided by the number of units produced during the period. This method is often chosen to avoid sharp fluctuations in inventory value.
In addition to these, there’s also the **Specific Identification Method**, which allows businesses to assign exact costs to specific inventory units sold. This is useful when products are unique or high in value.
Read: Understanding the Difference Between FIFO and LIFO Methods
What’s Excluded from COGS?
Certain components should be excluded from the COGS calculation. These include:
1. Non-Operating Costs: These are costs unrelated to the company’s core operations, such as capital expenditures or loan interest. Since they’re not tied to production or sales, they’re not counted in COGS.
2. Administrative Expenses: These include accounting fees, executive salaries, office rent, advertising, and distribution costs. Because they don’t directly contribute to production or sales, they’re excluded from COGS.
3. Production Costs for Unsold Goods: If goods are produced but not sold by the end of the period, their production costs are not included in COGS. These costs are instead reflected in the value of ending inventory.
These exclusions help ensure COGS accurately represents the expenses directly tied to producing and selling goods or services, without including unrelated overhead or indirect costs.
COGS Formula and How to Calculate It
Let’s walk through an example using data from Company A for 2022:
- Beginning Inventory: IDR 150 million
- Ending Inventory: IDR 80 million
- Gross Purchases: IDR 40 million
- Shipping Costs: IDR 5 million
- Discounts: IDR 1 million
- Returns: IDR 3 million
Based on this data, here’s how to calculate Company A’s COGS:
Step 1: Calculate Net Purchases
Net Purchases = (Gross Purchases + Shipping Costs) - (Returns + Discounts)
= (IDR 40 million + IDR 5 million) - (IDR 3 million + IDR 1 million)
= IDR 45 million - IDR 4 million = IDR 41 million
Step 2: Calculate COGS
COGS = Beginning Inventory + Net Purchases - Ending Inventory
= IDR 150 million + IDR 41 million - IDR 80 million
= IDR 111 million
So, Company A’s COGS for 2022 is IDR 111 million.
That wraps up our complete guide on COGS, including its components, formulas, sample calculations, and how to apply them. Understanding this concept is essential, especially for those looking to gain a deeper grasp of business fundamentals.
Of course, calculating COGS manually can be time-consuming and tedious. To simplify the process, you can use the free COGS Calculator provided by Opaper's POS system. With this tool, there’s no need to do manual calculations. Use the Opaper COGS Calculator to get quick and accurate results — so you can stay focused on running your business without worrying about complex math.