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Cost of Goods Sold or COGS in accounting refers to the cost borne by the company to produce or acquire the goods for selling purposes.
It includes raw materials, direct labor wages, production overheads, etc. COGS does not include any indirect expenses such as advertising and selling overheads.
COGS can be calculated using different methods like LIFO, FIFO, and weighted average method which will be discussed further below.
Businesses deduct COGS from revenue to determine gross profit in the income statement making it a valuable figure for management to assess the profitability.
Cost of goods sold is a very significant metric for a business because:
The Cost of Goods Sold includes all the expenses a company needs to pay during the production process or acquiring ownership of the goods. For example, COGS for a manufacturing company consists of direct material, labor, in-progress goods, factory overheads, storage expenses, etc. The same COGS for a service company consists of expenses like software subscriptions, salaries of consultants, research & development expenses, etc.
If you are confused about what to include in COGS, just ask yourself whether this expense exists if no production is done. If your realization is no, then it is most probably included in the COGS.
Examples of costs included in the Cost of Goods Sold are:
Answering the question about what not to include in COGS by asking yourself if this expense has not been paid, will it impact the production process? If the answer is no, there is a high chance that it is not included in COGS. Commonly, COGS does not consist of expenses related to selling and distribution of the product.
Examples of costs not included in the Cost of Goods Sold are:
The simplest way to calculate the Cost of Goods Sold in cost accounting is to add all the direct expenses related to the production of a specific period.
The formula for calculating COGS is:
Cost of Goods Sold = Opening Stock of Inventory + Purchases during the period – Closing Stock of Inventory
This result is directly used in the profitability calculation for the organizations in the income statement.
The Cost of goods sold can easily be calculated by using the free template for COGS Calculation provided below:
| COGS Statement of ________ for the year ending ______ | ||
| Particulars | Amount | Amount |
| Direct Material: | ||
| Opening Stock of Raw Material | xxx | |
| Add: Material Purchased | xxx | |
| Less: Closing Stock of Raw Materials | xxx | |
| Direct Labour | xxx | |
| Direct Expenses: | ||
| Carriage Inwards | xxx | |
| Royalties | xxx | |
| Prime Cost | xxx | |
| Add: Factory Overheads: | ||
| Indirect Material: | ||
| Cleaning Supplies | xxx | |
| Spare Parts | xxx | |
| Personal protective equipment | xxx | |
| Indirect Expenses: | ||
| Power and Fuel | xxx | |
| Factory Rent | xxx | |
| Water Supply | xxx | |
| Depreciation Expenses of Factory Machinery | xxx | xxx |
| Add: Opening Stock of Work-in-Progress | xxx | |
| Less: Closing Stock of Work-in-Progress | xxx | |
| Factory Cost/ Works Cost | xxx | |
| Add: Office & Administrative Expenses: | ||
| Office Rent | xxx | |
| Printing and Stationary | xxx | |
| Audit Fees | xxx | |
| Legal Charges | xxx | |
| Telephone and Postage | xxx | |
| Depreciation Expenses of Office Furniture | xxx | |
| Bank Charges and Commission | xxx | |
| Less: Scrap Sold/ Recoveries/ By-Product Produced | xxx | xxx |
| Cost of Production | xxx | |
| Add: Opening Stock of Finished Goods: | xxx | |
| Less: Closing Stock of Finished Goods | xxx | xxx |
| Cost of Goods Sold | xxx | |
Calculating COGS is easy as the formula contains only 4 elements.
To correctly calculate the amount of COGS, a series of steps can be followed below:
According to IFRS and US GAAP, there are multiple methods of inventory valuation in accounting. Inventory valuation is a method that helps organizations to find out the value of closing inventory for the preparation of financial statements. Different methods of inventory evaluation have different impacts on the calculation of the cost of goods sold which is explained below:
FIFO stands for First In and First Out, is an order of production approach that assumes the initial stock in inventory is sold first. It is usually seen that this method will provide a lower COGS as the new price will most probably be more than the old one. This approach is useful for businesses working with perishable goods or products with a short sell-by date.
LIFO stands for Last In and First Out, is a reverse production approach that assumes the latest stock in the organization was the first to be sold. Companies go with this approach to lower taxable income as it will provide a higher value for COGS. The LIFO method of valuation is used by gas and oil companies, resellers, car dealerships, etc
In cost accounting, the weighted average method works by arriving at an average cost of all the available inventory items that are available in the market for that period. This method is useful for businesses working with similar items whether they deal in production, wholesale, or retail. This method lowers the impact of actual and estimated prices in the future, eliminating the risk of price fluctuation and providing stability to the COGS calculation.
The formula for the weighted average method:
Weighted Average Unit Cost = Cost of Available Goods / Units Available for Sale
To better understand the workings of COGS, let us look at a simple example of the solution for COGS:
Raw Material Opening Stock: 300000
Raw Material Closing Stock: 450000
Finished Goods Opening Stock: 200000
Finished Goods Closing Stock: 275000
Work-in-Progress Closing Stock: 115000
Purchases during the Year:1500000
Direct Wages: 1120000
Carriage Inwards: 80000
Solution:
| Particulars | Amount | Amount |
| Opening Stock: | ||
| Raw Material | 300000 | |
| Finished Goods | 200000 | 500000 |
| Add: Purchased During the Year | 1500000 | |
| Less: Closing Stock | ||
| Raw Materials | 450000 | |
| Work-in-Progress | 115000 | |
| Finished Goods | 275000 | 840000 |
| Add: Direct Wages | 1120000 | |
| Add: Carriage Inwards | 80000 | |
| Cost of Goods Sold: | 4040000 |
The cost of goods sold and inventory share a bond that forms the central role of establishing the financial wellness of a company. This is because COGS cater to the expenses done during the company’s production process and create a major part of the income statement for gross profit calculations.
COGS depends on the direct cost components like raw materials consumed, direct labor, carriage, etc. Inventory management is also related to COGS. If a business has a high COGS, it will focus on a way that will reduce it by following the method of FIFO inventory management, and if the COGS is less, it will shift to ways like LIFO or weighted average method.
COGS and OPEX are both expenses borne by the company but are different:
| Basis | COGS | OPEX |
| Definition | COGS is the direct cost incurred by the business for the production of goods. | OPEX is an indirect cost borne by the business for day-to-day operations |
| Impact on Profit | Directly impact the gross profit calculations | Impacts operating income |
| Expense Incurred | Only when goods are produced | Not related to production or sales volume. |
| Examples | Raw Materials, Factory overheads, Purchases during the year | Insurance, Distribution Expenses, Legal Fees, Taxes |
COGS and Cost of Sales are used interchangeably but are very much different.
Below is a list of differences:
| Basis | COGS | Cost of Sales |
| Definition | COGS is the direct cost incurred by the business for the production of goods. | Cost of Sales is the total of expenses borne by a business including COGS. |
| Scope | Narrow Concept | Broad Concept |
| Focus | Only on the direct production expenses | All the expenses whether related to production or sales |
| Examples | Raw Materials, Factory overheads, Purchases during the year | COGS, Advertising Expenses, Distribution Expenses |
COGS and Cost or Revenue both are related to the financial wellness but are different:
| Basis | COGS | Cost of Revenue |
| Definition | COGS is the direct cost incurred by the business for the production of goods. | Cost of Revenue includes all the costs borne by the organization which will result in profit generation including COGS |
| Scope | Narrow Concept | Broad Concept |
| Relevance | Primarily important for production companies or companies selling a product. | Important for every company whether related to product or service. |
| Examples | Raw Materials, Factory overheads, Purchases during the year | COGS, Marketing Expenses, Accountant’s fees. |
COGS is a very important element for business but include components which can create problem if not calculated properly.
Some of the limitations of utilizing COGS are given below:
Cost of Goods Sold is a metric used in cost accounting for determining the cost of producing a good which includes direct labor, raw aerial, freight, etc. COGS is important for the business as it is utilized in the gross profit calculations. Many methods for inventory valuation will directly impact the calculation of COGS. Having a good understanding of COGS will help the business in better control of production expenses.
