The Cost of Goods Sold formula is: opening inventory plus purchases and production costs minus closing inventory. This formula can be used to calculate how much it costs to produce a saleable product. When compared with revenue, the cost of goods sold metric helps you understand your profitability at a product- and business-level.
Below, we explain what the cost of goods sold (COGS) is, why it’s important for product businesses, and how to calculate COGS using the cost of goods sold formula.
What is cost of goods sold?
Cost of goods sold (COGS) refers to the cost of producing or purchasing a product that is sold by a business. It’s an important inventory accounting metric for any company selling physical goods as it directly impacts profit margins and product pricing.
What’s included in cost of goods sold?
Cost of goods sold is generally calculated by adding up the following costs:
- Direct materials – The raw materials or parts used to create a product. This includes items like screws, wood, plastic, and cotton.
- Direct labour – The wages paid to the staff who create the product. This includes the cost of factory line workers, order fulfilment teams, and quality controllers.
- Manufacturing costs – The cost of overheads required for manufacturing the product. This includes factory rental, equipment purchases, and maintenance and warehousing requirements.
Cost of goods sold does not include indirect expenses, such as sales and marketing costs, office and administration costs, distribution, and any Government-related costs like taxes.
It’s possible to reduce Cost of Goods Sold by buying in bulk or when a discount is available, negotiating with or changing suppliers, and sourcing cheaper labour.
Cost of goods sold formula
You can calculate COGS using the formula:
Opening Inventory + Purchases + Production Costs – Closing Inventory = Cost of Goods Sold
You might be thinking, it’s all good and fine to have a formula for COGS but how do I determine the data inputs needed to make it work?
Don’t worry, we’ve got you covered.
How to use the COGS formula
To utilise the COGS formula, you’ll first need to decide on your cost of goods sold ‘period’. Often the assessment is made over a year, but it depends on your business and the solutions you may be trying to find.
Once that’s determined, assess the opening inventory. This refers to the inventory in the warehouse at the time the period starts.
Depending on what you’re assessing, opening inventory could mean the number of various goods in the warehouse, the number of boxes containing goods, or the number of raw materials and products being held.
At the end of the period, calculate your closing inventory by running through the same process you used to calculate your opening inventory. Compare the data to determine what’s changed throughout the period.
Next, consider the purchases you’ve made, and the production costs you’ve incurred, throughout the period. This will include the raw materials, labour, and manufacturing costs that are directly attributable to the relevant inventory.
Once you have all the elements outlined in the steps above you will be able to slot the data into the formula to calculate your cost of goods sold.
Cost of Goods Sold Calculator
Why the cost of goods sold formula matters
The COGS formula is important because it determines the direct costs of producing a certain number of goods during an identified period. This allows business managers or owners to make important financial calculations, such as understanding the gross profit and cost of inventory during that period.
Cost of goods sold is also an important figure for auditing purposes because it offers transparency over cost and earnings.
The COGS formula is used extensively throughout business, particularly when there are large amounts of inventory moving through a supply chain and onto the customer.
Benefits of using the cost of goods sold formula
Cost of goods sold is an essential metric for any business producing or selling goods.
Some of the core benefits of using the cost of goods formula include:
- The ability to assess your gross profit and understand the potential profitability of your business.
- The insights gained into the production costs and the ability to see where costs may be lowered, or other savings made.
- The clarity around which products may be more expensive than others to produce.
- The ability to understand the ebbs and flows of costs and if those can be managed in a way that is beneficial to the business.
Cost of goods sold is a widely recognised way of assessing costs associated with manufacturing products. But there are variances in how it is handled, which means it can be prone to errors, miscalculations, and inconsistencies.
Let’s look at some of these risks now.
Risks of using the cost of goods sold formula
The COGS formula only takes direct costs into account. Any indirect costs, such as administrative and office costs, marketing and advertising, and rental expenses are not captured by the formula.
Expenses must be categorised appropriately and consistently every time a COGS analysis is done. Otherwise, the results can be badly skewed.
Three best-practice tips for using the COGS formula:
- Use the same accounting system across the business so that when the full financial statements are done, the figures have all been assessed from the same baselines.
- Calculate comparative points in time – such as when opening inventory and closing inventory – that have the same underlying assumptions.
- Make sure the calculations are well recorded in time for the next COGS period. This ensures any variances in profits or losses over those periods can be compared.
Cost of sales vs. cost of goods sold
Cost of Sales and Cost of Goods Sold are often used interchangeably because they both reference the direct costs associated with producing or purchasing goods that are sold. However, they’re not always the same thing.
The main difference between COGS and cost of sales is that COGS refers to the cost of making a product, while cost of sales refers to the cost of a product which has been sold.
- Manufacturers generally refer to the COGS because they can tie specific costs back to the production of tangible goods, such as labour, raw materials, and machinery used.
- Service-only businesses generally lean toward the cost of sales because it is more difficult to assess the direct costs of a sale made.
Overall, the two terms are very similar as they’re used to reflect the cost of providing a service or goods, which is ultimately used to understand costs, revenues, and profit.
Cost of goods sold formula in accounting
Different accounting treatments can also yield different results of running the cost of goods sold formula.
The three most common inventory valuation methods used with COGS are:
- The FIFO accounting method: First-In, First-Out (FIFO) assumes the items purchased or produced first are also the first to be sold.
- The LIFO accounting method: Last-In, First-Out (LIFO) assumes the items purchased or produced first are the last to be sold.
- The average cost method: Unlike FIFO and LIFO, this method takes the average prices of the various goods that are in stock, without considering the purchase date of those goods.
Using the average cost methodology, the COGS calculation is smoothed out over that time. This means that spikes or drops in demand and purchasing costs do not have an unjustifiable significant impact on the final figures.
Is cost of goods sold an expense?
Cost of goods sold is considered an expense for accounting purposes. This is because it represents direct costs incurred in the production or purchases of goods during the accounting period.
COGS is included in the financial statement as a line item because it’s directly responsible for generating information about the business’s costs and profits. However, COGS is different from other operating expenses such as marketing, office, or overhead costs.
Cost of goods sold journal entry (with examples)
Inventory accounting journal entries for cost of goods sold generally require debiting the COGS and crediting the inventory account.
It’s important to ensure the accounting is consistent across various entries, and that you’ve used the right formula to assess the cost of your business.
Generally, a journal entry will look something like this:
- Date of the transaction
- Debit: The cost of goods sold
- Credit: Inventory
- Credit: Purchases
We’ve outlined a couple of examples below:
COGS journal entry: Example 1
On December 6 last year, the balance of your opening inventory was $8,500. This consists of caps, T-shirts, and tracksuit pants.
Through the COGS period, you purchase wool and cotton to make more items, along with additional items such as elastic and pre-made logos. You also pay for labour to create the products. The cost of all this is $3,000.
At the end of your six-month COGS period, you have $2,350 of closing inventory.
Your cost of goods sold journal entry would look like this:
Account Debit Credit
Cost of Goods Sold 9150
Total 9150 9150
COGS journal entry: Example 2
On Jan 18 this year the balance of your opening inventory was 50 designer light shades, each worth $2,000. Your opening inventory is therefore $100,000.
Over the next three months, you purchase 5 more of the same light shades, so your cost over this time is $10,000. You then sell 10, so your closing inventory is $90,000.
Your cost of goods sold journal entry would look like this:
Account Debit Credit
Cost of Goods Sold 20000
Total 20000 20000
There are likely additional costs you will need to journal to get a full picture of your costs, revenue, and profits. Separate accounting lines will be used for these, and they will be debited or credited as suits your accounting system and business structures.