Cost of Goods SoldDefined with Formula & Calculations

Patrick Louie

Date Published: February 24, 2022

The goods that a business sells come with a cost.

It’s not like they appear out of nowhere after all.

Manufacturing goods isn’t free.

You have to consider the cost of raw materials, direct labor, and other necessary manufacturing that a business incurs as they produce them.

Even retailers and wholesalers of goods have to purchase what they sell.

It’s why consumer products aren’t free.

On top of making a profit, the business has to cover the cost of the goods its sells.

We refer to this type of cost as the cost of goods sold (COGS).

The cost of goods sold (COGS) is an important metric for any business that sells goods.

It greatly influences the profit generation of a business.

A business can only generate a profit if its revenue exceeds its COGS as well as operating expenses.

In fact, COGS is a good basis for the sales price of a product.

For example, if a product’s cost is $15 per unit, then the sales price must be more than $15 for the business to make a profit.

Selling for a lower price means that the business will incur losses.

Understanding how COGS works is essential if you want your business to be profitable.  

That’s why in this article, we will be learning about COGS.

We will learn of its definition, as well as the different costs that qualify as COGS.

At the end of the article, I will be leaving some exercises so that you can deepen your understanding of COGS.

Cost of Goods Sold (COGS): What is it?

cost of goods manufacturing

Cost of goods sold refers to the total amount of costs incurred that can be directly attributed to the sale of a product/s.

What comprises COGS will vary from business to business.

For example, the COGS of a manufacturing company will differ from a business that purely does retail sales.

Businesses that purely sell services don’t accumulate COGS.

Rather, they accumulate a similar cost account which is the cost of services.

Typically, in a manufacturing setting, the COGS will consist of three types of costs: the cost of direct materials, the cost of direct labor, and manufacturing overhead.

Direct materials refer to the raw materials used in the manufacturing of a unit of product.

What’s considered as direct materials will depend on the product that the business manufactures or produces.

For example, the raw materials of bread are typically eggs, flour, and yeast.

Direct labor refers to the amount of work directly related to the manufacturing of a product.

The cost of direct labor includes the salaries and wages of employees that are directly involved in the manufacturing process of a product.

It also includes the payroll taxes associated with said salaries and wages, plus any other additional compensation (e.g. insurance, pension, etc.).

Finally, manufacturing overhead refers to all indirect costs that a business incurs in the manufacturing or production process.

Examples of manufacturing overhead are the following:

  • Utilities and maintenance cost of equipment used in the manufacturing process
  • Rent for the space or building that houses the manufacturing process
  • Salaries and wages of manufacturing managers
  • The cost of factory supplies such as glue, oil, and lubricants
  • Wages of the janitorial staff

As for a business that sells merchandise, COGS will mainly consist of the costs that the business incurs to acquire the goods and make them available for sale.

Why COGS matters for your business

The primary purpose of running a business is to generate profits.

But in order to generate a profit, the business must generate revenue that exceeds the cost of running the business.

That includes the cost of goods sold (COGS).

A business can generate any amount of revenue, but if the amount of revenue does not even cover the business’s COGS, it won’t be making any profit.

Worse, it will incur losses instead.

In most income statements, the line item that comes after “sales” or “revenue” is the “cost of sales” or “cost of goods sold”.

That makes COGS a great indicator of a business’s profitability. Ideally, revenue must exceed the cost of sales.

This ensures that the business generates an operating profit or gross profit.

Knowing your business’s COGS will help you in steering your business towards making profits.  

If you know the costs of the products that you’re selling, you would know the appropriate sales price for each product so that you don’t incur an operating loss.

For example, if the cost of a unit of the product you’re selling is $5, you would know that selling it at a lower price will not make you any profit.

Likewise, selling it at $5 will only cover the cost of the product.

It will not cover your business’s operating expenses.

Rather, you know that you’ll have to sell the product for more than $5 if you want to make a profit.

Do note that a business will only incur COGS when it sells a product.

The cost of any unsold products is instead included in a business’s inventory.

When the products are sold, that’s the time when the business incurs COGS.

cost of goods manufacturing

The COGS Formula

To calculate a business’s COGS, you will need to acquire three data:

  • The cost of beginning inventory
  • Purchases made for the concerned period; and
  • The cost of ending inventory

To calculate COGS, you simply need to add the cost of purchases to the cost of beginning inventory then subtract the cost of ending inventory.

Put into formula form, it should look like this:

Cost of Goods Sold = Beginning Inventory + Purchases – Ending Inventory

Keep in mind that COGS literally means the cost of goods sold.

This means that the cost of unsold products is not included in a business’s COGS.

Rather, it goes to the inventory of the business.

This is why the COGS formula subtracts the cost of ending inventory from the cost of goods available for sale (beginning inventory + purchases).

For businesses that sell manufactured goods, the COGS formula will be different.

Since a manufacturing business will have different inventory accounts for raw materials, work in progress, and finished goods, we need to specify which inventory account we will be using in the formula.

A manufacturing business will typically only sell finished goods.

As such, we will be using the finished goods inventory account for the computation of COGS.

Also, purchases typically increase the raw materials inventory account rather than the finished goods inventory.

What increases finished goods inventory instead is the cost of goods manufactured.

With these considerations, the COGS formula for manufacturing business will be:

Cost of Goods Sold = Finished Goods Inventory, Beginning + Cost of Goods of Manufactured – Finished Goods Inventory, Ending

If you want to do the computation of COGS from the start of the manufacturing process, you can refer to this template:

Inventory Costing Methods and How They Affect COGS

How a business values its inventory will affect its value for COGS.

The value of products changes over time.

That’s why the COGS will change depending on the inventory costing method that the business uses.

For example, using the FIFO (First In, First Out) method means that the cost of the earliest product acquired or produced will be subtracted first from the inventory when a product is sold.

It could also mean that the oldest stocks are to be sold first rather than the newer ones.

FIFO (First In, First Out)

A method that assumes that the oldest stocks are sold first before the newest ones.

Thus, the cost of the oldest stocks will be used for determining the COGS.

Since the value of products usually go up as time goes by, using the FIFO method means that the business will usually sell its least expensive products first.

This also translates to lower COGS and ultimately higher net income.

LIFO (Last In, First Out)

A method that is the opposite of FIFO. LIFO assumes that the business sells its newest stocks first before the oldest ones.

Thus, the cost of the newest products determines the COGS. Since the newest products are usually more expensive than the older ones, this usually means that a business will be recording a higher COGS when compared to using FIFO.

Weighted Average Cost (WAC)

A method that uses a weighted cost that averages the cost of inventory.

Whenever stocks go in or out, the business recomputes the cost of each unit of inventory to determine the weighted average cost.

Using the WAC method reduces the effects of varying prices.

Instead of basing it on the cost of the oldest or newest stocks, the business bases its COGS on the movement in inventory.

Specific Identification

A more particular method in which the business assigns each product or material its own cost.

This method is most suited for businesses that have products that are very different from each other (e.g. auction houses, personalized items, etc.).

The COGS will greatly depend on the cost assigned to the product being sold.

COGS vs Operating Expenses

We can divide the cost of running a business into two categories: the cost of sale or cost of goods sold, and operating expenses.

Not all expenses qualify as COGS.

As a general rule of thumb, a business will only incur COGS if it makes a sale while it will incur operating expenses regardless of whether it makes a sale or not.

Furthermore, operating expenses are those expenses that cannot be directly attributed to the acquisition or production of a product.

However, they’re still important to keep the business running.

While we can relate COGS to the sale of a product, we can’t say the same with operating expenses.

Rather, we can associate operating expenses with the passage of time.

Whether the business makes a sale or not, as long it is operating, it will continue to incur operating expenses.

Another term for operating expenses is “selling, general, and administrative expenses”.

In most income statements, the COGS and operating expenses are segregated.

Here are some examples of operating expenses:

  • Rent for the space that houses the administrative function
  • Salaries and wages of administrative staff
  • Advertising and promotion expenses
  • Office supplies expense
  • Salaries and wages of sales staff
  • Training and development expense
  • Travel and transportation costs

COGS: Exercises

Exercise#1

MD company is a newly formed business.

It deals with the sale of RTW (ready to wear) clothing.

In its first year, MD company has total purchases of $650,000.

As per the year-end inventory count, it still has $230,000 remaining worth of unsold products.

Our task is to compute MD company’s COGS.

First, we need to determine the following:

  • Cost of beginning inventory
  • Purchases
  • Cost of ending inventory

Since MD company is newly formed, it does not have a beginning inventory yet.

Thus, the cost of beginning inventory is zero. As for purchases, it is already stated that MD company made a total of $650,000 purchases for the year.

Lastly, the cost of ending inventory will be equal to the cost of unsold goods, which is $230,000 in this case.

Now that we have the data we need, we can finally compute MD company’s COGS:

Cost of Goods Sold = Beginning Inventory + Purchases – Ending Inventory

= $0 + $650,000 – $230,000

= $420,000

As per computation, MD company’s COGS for the year amounts to $420,000.

Exercise#2

EM company manufactures its products.

The following is information about its inventory accounts:

The following are additional data regarding EM company’s manufacturing costs:

  • Total purchases of raw materials amount to $631,600
  • The cost of direct labor amounts to $429,000
  • Total manufacturing overhead amounts to $817,300

Our task is to compute EM company’s COGS. To do so, we need to gather the following data:

  • The cost of beginning finished goods inventory
  • Cost of goods manufactured
  • The cost of ending finished goods inventory

We already have the data for EM company’s beginning and ending finished inventories, which are $127,000 and $99,980 respectively.

What we’re missing is the cost of goods manufactured.

To compute the cost of goods manufactured, we need to use the following formula:

Cost of goods manufactured = WIP inventory, beginning + Total Manufacturing Costs – WIP Inventory, ending

Still, we are missing another piece of information which is the “total manufacturing costs”.

Thankfully, we can compute it using the following formula:

Total Manufacturing Costs = Cost of Direct Materials Used in Production + Cost of Direct Labor + Manufacturing Overhead

Where:

Cost of Direct Materials Used in Production = Raw Materials Inventory, Beginning + Purchases of Raw Materials – Raw Materials Inventory, Ending

Thus, we will be doing the following set of computations to finally arrive at the COGS:

Cost of Direct Materials Used in Production

Cost of Direct Materials Used in Production = Raw Materials Inventory, Beginning + Purchases of Raw Materials – Raw Materials Inventory, Ending

= $175,000 + $631,600 – $132,000

= $674,600

Total Manufacturing Costs

Total Manufacturing Costs = Cost of Direct Materials Used in Production + Cost of Direct Labor + Manufacturing Overhead

= $674,600 + $429,000 + $817,300

= $1,920,900

Cost of goods manufactured

Cost of goods manufactured = WIP inventory, beginning + Total Manufacturing Costs – WIP Inventory, ending

= $88,700 + $1,920,900 -$102,360

= $1,907,240

And finally,

Cost of Good Sold

Cost of Goods Sold = Finished Goods Inventory, Beginning + Cost of Goods of Manufactured – Finished Goods Inventory, Ending

= $127,000 + $1,907,240 – $99,980

= $1,934,260

As per computation, EM company’s COGS amount to $1,934,260.

We can also use the template we had earlier to show the computation of COGS:

 

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