As already mentioned, cost of goods sold includes the money that is spent on manufacturing the stuff that a company sells. Various prices are included this term. The exact terms for the prices that are included in the cost of goods sold may differ from one business to another. It will be different for a service-based company and a product-based company. The costs may include the money that was spent in production, as well as modifying the product, in case it needs to be modified. Both companies (service-based and product-based) include money spent on labor, raw material, quality control, shipping charges, etc.
Cost of Goods Sold = Beginning Inventory + Purchases - Ending Inventory
Beginning inventoryInventory is basically the merchandise that is purchased by traders, wholesalers, distributors, and retailers. Whatever is purchased (but not sold yet) is included in the income statement as merchandise or beginning inventory. This term is considered as an important current asset of the business. It is the recorded cost of inventory at the end of an accounting period, which is carried forward to the beginning of the next accounting period.
PurchasesThis is the cost of goods manufactured. Throughout the year, the factory may be manufacturing and adding products. This includes extra shipment charges, invoices, paperwork, materials, supplies, and other purchased products.
Ending InventoryIt is the amount of inventory that a company has in its stock at the end of the year. It can be considered as the value of the goods yet to be sold at the end of the accounting period. It can also include damaged or worthless inventory.
To determine which inventory is left at the end, there are two methods that are described below.
It is an inventory costing method in which the first items placed in the inventory are the first ones to be sold. This means that the ending inventory, if calculated by this method, will consist of the most recently placed products. Theoretically, it is considered a logical evaluation method, since this assumption closely matches the actual flow of products.
In this method, it is assumed that the last items placed in the inventory are the first ones to be sold. Therefore, the ending inventory will consist of the goods that were placed at the very beginning of the year.
Included CostsThe costs that are included in the formula, and are divided between the 3 terms above, can be roughly classified as direct and indirect costs. Direct costs include raw materials, work in progress, packaging, production supplies, cost of inventory of finished goods, overhead expenses, like utilities, rent, etc. Indirect costs include labor, storage, equipment, salaries (of all the staff, managers, etc.), warehousing, manufacturing supplies, etc.
Step 1: Calculate the beginning inventoryAs mentioned earlier, this is the ending inventory from the previous accounting period. If you manufacture items, this term will include all the stuff you're planning to sell. It will also include the expenses of raw materials and other supplies.
Step 2: Calculate the purchases madeThese are your inventory purchases. If you are a manufacturer, this includes the cost of the materials that go into manufacturing your products. It can be calculated by adding the expenses from each invoice (for all the products of the month). Also, calculate the labor and supplies costs. This means staff salaries, overhead expenses, like rent, heat, light, power, etc.
Step 3: Calculate the cost of goods availableThis value can be obtained by adding the values of the above two steps. Add the beginning inventory and the purchases. Set this value aside.
Step 4: Calculate the ending inventoryThis value can be obtained by following the FIFO or LIFO methods mentioned above. It usually includes rejected or obsolete goods.
Step 5: Calculate the cost of goods soldNow, subtract the ending inventory from the cost of goods available (step 3). Thus, you will obtain the cost of goods sold.
# 1Let us assume you own a business that supplies stationery to offices. If, at the end of the current fiscal year, you have USD 900 as ending inventory, this will become your beginning inventory for the forthcoming fiscal year. Then, let's say, you buy stationery stock worth USD 2,500. At the end of this year, after selling your goods, let the ending inventory be USD 500. Then, your COGS will be:
COGS = Beginning inventory + purchases - ending inventory
= 900 + 2500 - 500
= 3400 - 500
Thus, COGS = 2900
# 2Consider a simple example. Suppose you manufacture home-made chocolates. Now, your raw materials will include the ingredients, like cocoa powder, milk, sugar, nuts, etc. If you are making them yourself, great, but if you have help at hand, he/she would come under labor costs. Also, you will be using a food processor, bowls, wrapping paper, electricity, etc. These will comprise the overheads, manufacturing, and packaging costs. Now, assume that your total inventory purchases, including the direct and indirect expenses would amount to about USD 500. And, if you have some inventory left from last month (assuming the accounting period to be on a monthly basis, since it is a small-scale business), let's say it amounts to USD 80. After selling all the chocolates, say you have USD 100 left for this month. Then, your COGS would be:
COGS = 80 + 500 - 100
= 580 - 100
Therefore, COGS = 480
- COGS can be deducted only if you have sales. If products are manufactured but not sold, the cost cannot be deducted.
- Most companies commonly use the FIFO method.
- Calculating the COGS is important, as it is the main component that helps determine the gross profit.
- If the market price of raw materials or labor (or any other expense for that matter) increases in the middle of the year while you are either purchasing or manufacturing items, it is bound to affect the COGS value.
- Since retailers usually buy finished items, they have only one inventory method to consider, i.e., they do not include the direct expenses or work in progress in their calculation.
- Using different inventory valuation methods may result in obtaining different COGS values.
Disclaimer: This article is for reference purposes only and does not directly recommend any specific financial course of action.