Cost of Goods Sold (COGS): Definition, Formula, Calculation and Example

The cost of goods sold (COGS) is the sum of all direct costs associated with manufacturing a product. It appears on a manufacturer’s income statement and typically includes money spent on raw materials and labor as well as amortization expenses. It does not include costs associated with marketing, sales, or distribution.

Purpose of Cost of Goods Sold

The basic purpose of finding COGS is to calculate the “true cost” of merchandise sold in the period. It doesn’t reflect the cost of goods that are purchased in the period and not being sold or just kept in inventory. It helps management and investors monitor the performance of the business.

Purpose of Cost of Goods Sold

What is the cost of goods sold?

Your cost of goods sold, also known as cost of sales or cost of services, is how much it costs to produce your business’s products or services. COGS include the following costs:

  • Direct labor
  • Materials to create the good

The cost of goods sold only includes the expenses that go into the production of each product or service you sell (e.g., wood, screws, paint, labor, etc.). When calculating the cost of goods sold, do not include the cost of creating products or services that you don’t sell. 

COGS excludes indirect costs, such as distribution expenses. Do not factor things like utilities, marketing expenses, or shipping fees into the cost of goods sold. Again, COGS only includes the production costs. 

What Is Included in Cost of Goods Sold?

COGS includes all direct costs incurred to create the products a company offers. Most of these are the variable costs of making the product—for example, materials and labor—while others can be fixed costs, such as factory overhead.

A good litmus test to determine whether something should be included in COGS is to ask: Would the cost exist if no products were produced? If the answer is no, then the cost is likely included in COGS.

Examples of costs generally considered COGS include:

  • Raw materials
  • Items purchased for resale
  • Freight-in costs
  • Purchase returns and allowances
  • Trade or cash discounts
  • Factory labor
  • Parts used in production
  • Storage costs
  • Factory overhead

Exclusions From COGS

On the flip side, items that are excluded from COGS include selling, general and administrative expenses such as distribution costs to customers, office rents, advertising, accounting, legal fees, and management salaries. Logically, all nonoperating costs, such as interest and capital expenditures, are excluded from COGS, too.

Also excluded from COGS are the costs for products that remain unsold at the end of a given period. Instead, these are reflected in the inventory on hand at the end of the period.

Presentation of the Cost of Goods Sold

In the income statement presentation, the cost of goods sold is subtracted from net sales to arrive at the gross margin of a business. This information appears near the top of the income statement.

What Is Included in Cost of Goods Sold?

Calculation of COGS Using Different Methods

The value of the cost of goods sold depends on the inventory costing method adopted by a company. There are three methods that a company can use when recording the level of inventory sold during a period: First In, First Out (FIFO), Last In, First Out (LIFO), and the Average Cost Method.

FIFO

The earliest goods to be purchased or manufactured are sold first. Since prices tend to go up over time, a company that uses the FIFO method will sell its least expensive products first, which translates to a lower COGS than the COGS recorded under LIFO. Hence, the net income using the FIFO method increases over time.

LIFO

The latest goods added to the inventory are sold first. During periods of rising prices, goods with higher costs are sold first, leading to a higher COGS amount. Over time, the net income tends to decrease.

Average Cost Method

In this method to calculate COGS, it is assumed that the inventory cost is based on the average cost of the goods available for sale during the period. The average cost is computed by dividing the total cost of goods available for sale by the total units available for sale. This gives a weighted-average unit cost that is applied to the units in the ending inventory.

Special Identification Method

This method uses the specific cost of each unit of the inventory or the goods, to derive the ending inventory and COGS for each period. With the help of this method, a business owner or accountant can identify which item was sold at what cost. 

Cost of goods sold formula 

Calculating COGS is pretty straightforward. To find the cost of goods sold, use the COGS formula:

COGS = Beginning Inventory + Purchases During the Period – Ending Inventory

Not sure where to get the above information to plug into the formula? No worries—here’s a breakdown of everything you need:

  • Beginning inventory: Amount of inventory left over from the previous period (e.g., month, quarter, etc.)
  • Purchases during the period: Cost of what you purchased during the accounting period
  • Ending inventory: Inventory you did not sell during the period

After you gather the above information, you can begin calculating the cost of goods sold. Depending on your business and goals, you may decide to calculate COGS weekly, monthly, quarterly, or annually. 

Example of Calculating the Cost of Goods Sold

A company has $10,000 of inventory on hand at the beginning of the month, expends $25,000 on various inventory items during the month, and has $8,000 of inventory on hand at the end of the month. What was its cost of goods sold during the month?  The answer is:

$10,000 Beginning inventory + $25,000 Purchases – $8,000 Ending inventory
= $27,000 Cost of goods sold

FAQs

Are salaries included in COGS?

No. Salaries and other general and administrative expenses are not included in COGS. But, certain types of labor costs can be included in COGS, provided that they are directly associated with specific sales.

How Are Cost of Goods Sold and Cost of Sales Different?

The cost of goods sold is the amount at which the end product is sold. However, costs in making those goods, which include raw materials, labor, utilities, and all other costs required are categorized as costs of sales.

Leave a Comment