The definitive guide to cost of goods sold (COGS)

Cost of goods sold (COGS) reflects all the direct costs associated with making a business's products or services. It might include money spent on raw materials, labor, and manufacturing overhead.

COGS is a major input in a company's profitability and overall financial health, so understanding how it works is crucial for any business owner or manager.

This guide covers the fundamentals of COGS, including what it includes and how to use it, helping business owners better manage their production costs, optimize pricing, and improve profitability.

What is cost of goods sold?

Cost of goods sold (COGS) is a financial metric representing the direct costs associated with producing the products or services a business sells, although in service companies it's usually called cost of sales (COS).

Because COGS is more prevalent in product-based businesses, we'll focus on that definition throughout this article.

What's included in the cost of goods sold calculation?

Cost of goods sold includes several elements:

1. Direct materials. These are the raw materials and components used to manufacture a product or purchase a product for resale. For example, for furniture manufacturers, direct materials include wood, screws, and varnish.
2. Direct labor. This includes wages and salaries for employees who are directly involved in production.
3. Manufacturing overhead. These are costs related to production, including utility costs for a factory, depreciation on equipment, and maintenance expenses.
4. Storage costs. This includes the cost of storing raw materials and finished products waiting to be sold.
5. Freight and shipping costs. This is the cost of getting sold products to customers.

COGS doesn't include indirect expenses like salaries and wages for sales and administrative employees, legal fees, travel costs, office supplies, interest on loans, etc. These are operating expenses, and they appear elsewhere in the financial statements.

Why is cost of goods sold important?

Calculating cost of goods sold provides valuable insight into a business operations. Here are a few ways business owners, managers, and their investors and advisors might use it:

1. Gross profit calculation. COGS is part of gross profit, which is calculated by subtracting COGS from total revenue. It's a key indicator of a company's profitability and reflects the efficiency of its production processes.
2. Pricing. Understanding COGS helps a business set competitive and profitable prices for its products. Knowing the exact cost involved in producing a product allows business owners and managers to price products at a level that covers all costs and generates a profit margin.
3. Budgeting and forecasting. COGS helps business owners plan and allocate resources, forecast future expenses, and prepare for potential financial challenges.
4. Tax reporting. Businesses can deduct COGS from gross receipts to reduce taxable income. Business tax returns require separately reporting COGS and operating expenses, so properly accounting for COGS helps companies with tax reporting.
5. Operational efficiency. Analyzing COGS helps management pinpoint areas where they can reduce costs and improve operational efficiency.

The bottom line? COGS isn't just a number on a financial statement—it's a useful tool for managing the business.

How to calculate cost of goods sold

The cost of goods formula is simple:

Cost of goods sold = beginning inventory + purchases - ending inventory

Here's a breakdown of each component:

1. Beginning inventory is the book value of the inventory on the company's balance sheet at the start of the accounting period.
2. Purchases include all labor, inventory, and raw materials purchased or produced during the accounting period.
3. Ending inventory is the book value of the inventory that remains unsold at the end of the accounting period.

Cost of goods sold examples

Let’s look at a fictional small furniture manufacturing business, ABC Furniture Co., to illustrate how to calculate COGS.

• Beginning inventory (January 1): $10,000
• Purchases during the year (raw materials and direct labor): $50,000
• Ending inventory (December 31): $15,000

Using the cost of goods sold formula, we calculate COGS as follows:

COGS = $10,000 + $50,000 - $15,000

COGS = $45,000

So ABC Furniture Co.'s cost of goods sold for the year is $45,000.

COGS and the relationship between direct and indirect costs

To accurately calculate COGS, you need to understand the difference between direct and indirect costs. COGS only includes direct costs associated with producing goods or buying products for resale. So here's a closer look at direct and indirect costs.

Direct costs

Direct costs are expenses you can directly trace to producing goods or services. Some common examples include raw materials, direct labor, manufacturing supplies, freight and shipping, and storage costs.

These costs are included in the calculation of COGS.

Indirect costs

These costs are business expenses that aren't directly tied to producing a product or service. Some examples include office rent, administrative salaries, sales commissions, marketing costs, and insurance.

Indirect costs support the business's overall operations, but they're not included in COGS. Instead, you'll find them in the operating expenses section of the income statement.

Business metrics that use cost of goods sold

You might find cost of goods sold when calculating other metrics or key performance indicators (KPIs) for your business. Here are a few metrics that incorporate COGS:

Gross profit

Gross profit = Total revenue − COGS

Gross profit is the profit a business makes after subtracting all costs related to manufacturing products and services but before deducting operating expenses, taxes, or interest. It shows how efficiently a company uses its resources to produce goods.

Gross profit margin

Gross profit margin = (Total revenue - Cost of goods sold) / Total revenue

Gross profit margin is a percentage that shows how much revenue a company keeps after subtracting cost of goods sold. It's useful for analyzing trends and comparing a business to industry benchmarks.

Net income

Net Income = Gross income - Deductions

or

Net Income = Gross profit − Operating expenses − Taxes − Interest

Net income, also known as net profit or "the bottom line," is the amount of revenue remaining after deducting all expenses. A lower COGS leads to higher net income, assuming operating expenses remain constant.

Inventory turnover ratio

Inventory turnover ratio = Average inventory / Cost of goods sold​

Inventory turnover is the number of times a company sells and replenishes its inventory over an accounting period. Managers and other users of financial statements might use this metric to measure how efficiently a company manages its inventory. A higher ratio is better than a low one, as a high ratio indicates the company is selling and replenishing inventory quickly, reducing holding costs, and minimizing obsolete inventory.

Inventory valuation and cost of goods sold

How a company values its inventory affects its cost of goods sold because it influences beginning and ending inventory amounts.

There are three primary inventory valuation methods to choose from.

First-in, first-out (FIFO)

The FIFO method assumes the business sells its oldest inventory items first.

For example, say a company has three batches of inventory:

• Batch 1: 100 units at $10 each
• Batch 2: 100 units at $12 each
• Batch 3: 100 units at $14 each

The company sells 150 units. Using the FIFO method:

COGS = (100 × $10) + (50 × $12) = $1,000 + $600 = $1,600

FIFO is a popular inventory valuation method because ending inventory better reflects current market conditions. It also typically results in higher gross profits during periods of rising prices, as older, cheaper costs are matched against current revenues.

Last-in, first-out (LIFO)

The LIFO method assumes the business sells its newest inventory items first.

Returning to the example above, if the company sells 150 units, under the LIFO method:

COGS = (100 × $14) + (50 × $12) = $1,400 + $600 = $2,000

LIFO raises cost of goods sold and lowers the company's taxable income.

Weighted average

The weighted average method values inventory by dividing the cost of goods available for sale by the number of units available for sale.

Returning to our example, the weighted average of the three inventory batches is:

(100 x $10) + (100 x $12) + (100 x $14) = $1,000 + $1,200 + $1,400 = $3,600 / 300 = $12

So using the weighted average method, cost of goods sold for the 150 units sold is:

$12 x $150 = $1,800

The weighted average cost method simplifies inventory management by averaging costs and reduces the impact of price volatility on financial statements. However, it's best for companies with a large number of identical inventory items.

Streamline financial reporting with automation

Most product-based companies have multiple vendors and suppliers to pay every month, and tracking expenses related to direct materials, direct labor, and manufacturing overhead can be complicated and time-consuming.

Fortunately, technology offers a way to streamline expense tracking and help ensure the company accurately records and categorizes all of those costs so they're reflected in COGS.

BILL Accounts Payable can be a big help in simplifying and automating calculating and managing COGS and other administrative expenses. This allows you to focus more on growing the business rather than getting bogged down by complex calculations and paperwork.

Learn more about BILL Accounts Payable

Costs of goods sold FAQ

Now, let's address some of the most frequently asked questions about cost of goods sold.

How do you record cost of goods sold?

Record COGS in your income statement by subtracting the ending inventory from the sum of beginning inventory plus any purchases made during the period. This amount is usually the second line on an income statement, after revenue and before gross profit.

Is COGS on a balance sheet?

No, COGS is not on the balance sheet. You'll find it on the income statement. You subtract COGS from total revenue to determine gross profit.

What is cost of goods sold vs. expense?

COGS is a subcategory of expenses that accounts for the direct costs of producing goods or purchasing inventory for resale. Total expenses include all other costs related to running the business, such as rent, utilities, administrative salaries, and loan interest.