How to Calculate COGS (Cost of Goods Sold)
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Cost of Goods Sold (COGS) is one of the most fundamental concepts in your business's finances. It's one of the first sections on your income statement, affecting how you report your business taxes. And like many aspects of bookkeeping and finance, it can be unclear if you don't have a background in the field. So we're here to clear it up.
COGS are the costs your business incurs to create and deliver your Product or Service. If your company sells finished goods purchased from manufacturers, those purchasing costs are also included in your COGS. It's important to remember that COGS only has costs directly involved with creating or purchasing your product and getting it to your customers – overhead costs like marketing are considered operating expenses instead (more on that later).
What we will cover in this article:
- Why Does COGS Matter?
- How to Calculate COGS for Physical Goods
- How to Calculate COGS for Services
- COGS vs. Operating Expenses (OPEX)
COGS are the costs your business incurs to create and deliver your product or Service. If your company sells finished goods purchased from manufacturers, those purchasing costs are also included in your COGS. It's essential to remember that COGS only has costs directly involved with creating or purchasing your product and getting it to your customers – overhead costs like marketing are considered operating expenses instead (more on that later).
Example: COGS for a Physical-Goods Business
Sample Fitness designs and produces athleisure clothing, which it sells directly to consumers through its website and select brick-and-mortar channel partners. The website also offers a small range of related lifestyle products like aromatherapy candles and reusable water bottles, which Sample Fitness purchases wholesale from partner brands.
Sample Fitness's COGS would include things like:
- Salaries for its clothing designers
- Raw materials used in creating the clothes
- Costs paid to its contract manufacturers to produce the finished clothing items.
- Purchasing costs for acquiring the lifestyle products that Sample Fitness sells but does not produce itself
- Freight costs for shipping finished products from the factories to Sample Fitness's warehouses.
- Tariffs and customs for bringing the products into the United States from the overseas factories
- Fulfillment expenses, like the cost of warehouse storage and picking/packing products to ship
- Shipping costs to deliver the product to end buyers, including both consumers and channel-partner retailers.
- Inventory shrinkage and obsolescence
Example: COGS for a SaaS Business
Sample Data develops business analytics software to help large companies better understand their marketing and sales funnels, which it sells on an annual subscription plan. The software leverages a toolset created by a different tech company. Sample Data pays a license fee to include it in their product. In addition to the annual subscription, new customers also pay Sample Data a 10% setup fee to cover technical implementation and training for the end users, which a third-party integration partner usually handles.
Sample Data's COGS would include things like:
- Salaries for any employees directly involved with building the product and ensuring customers can access and use it, such as software engineers, product designers, DevOps engineers, customer support team
- Costs for web hosting, such as AWS
- License fees for the third-party toolset
- Fees paid to the third-party integrators for their services during the customer implementation
Why does COGS matter?
COGS is one of your company's most critical financial metrics, regardless of your business type. Your cost of goods sold tells you how efficiently you create your product, affecting your business's gross profitability.
Tracking your COGS against your revenue can help you see opportunities to lower costs and increase your profitability. For example, suppose your COGS is high enough that they're eating into most of your revenue. In that case, you can look closely to see where you can renegotiate a supplier contract or make a process more efficient.
COGS can impact your business taxes if you make or sell physical goods. Some businesses can claim a deduction for their COGS, lowering their overall taxable income. If you opt to do this, you must keep accurate books. Working with a tax professional experienced in your industry is also a good idea to lower your chances of making errors that might lead to IRS penalties.
How to Calculate COGS for Physical Goods
For companies that sell physical products, calculating COGS first means determining the value of their inventory. There are several possible inventory valuation methods:
First In, First Out (FIFO)
This method assumes that your oldest inventory is sold first. For example, say a business acquired 500 units of a particular product for $20 each and then acquired another 800 units for $10 each. Under the FIFO method, the first 500 sales of the company's product will be valued at $20, regardless of whether the individual product sold was part of the $20 batch or the $10 batch. After 500 units are sold, the next 800 units will be valued at $10 each.
Last In, First Out (LIFO)
This method assumes that your newest inventory is sold first. Let's go back to the business from our first example, which acquired 500 units of their product for $20 each and then acquired another 800 units for $10 each. If the business used the LIFO method, its first 800 sales of that product would be valued at $10 each – assuming it did not acquire more, newer inventory before then.
If the company sold 300 units valued at $10, then acquired an additional 100 product units for $12 each, its subsequent 100 sales would be valued at $12. After that, it would resume valuing sales for $10 until it ran through the rest of the 800 units or acquired newer inventory.
This method takes the weighted average of all units and uses that number to value the cost of sales. Our example company acquired 500 units of their product for $20 each and another 800 units for $10 each. If the business uses the average cost method, then it would calculate the weighted average of all its current stock of that product:
(500×20+800×10) / (500+800) = 13.84
The weighted average is 13.84, so all 1300 sales would be valued at $13.84 under this method.
The COGS Formula
Regardless of your method, you must complete inventory valuation to calculate your COGS.
The COGS formula for businesses that sell physical goods is this:
Beginning Inventory Cost + Purchases – Ending Inventory Cost = Cost of Goods Sold
Step 1: Value your business's inventory at the beginning of the accounting period. This might be a month, year, or quarter.
Step 2: Add the costs of purchases your business made to create your products. This includes raw materials, direct labor, and manufacturing overhead costs.
Step 3: Value the inventory your business had at the end of the accounting period
Step 4: Subtract the ending inventory cost from the combined starting inventory and purchase costs. The resulting number is your COGS for that accounting period.
How to Calculate COGS for Services
While the concept for COGS and Cost of Service (COS) is the same – totaling the costs of providing your product – COS is calculated differently. Since service-based businesses generally do not have physical inventory, concepts like FIFO and LIFO don't apply. Instead, you add up the direct costs of providing your Service.
The Cost of Service (COS) Formula
Calculating COS is much more straightforward than COGS. For example, the COS formula for businesses that sell services is this:
The sum of All Direct Costs of Providing Service = COS
For many service businesses, the bulk of their direct costs will be labor. If material goods are involved in providing your Service, however, those costs will also be included here.
Let's look at some examples.
Company A provides business consulting services. It employs ten consultants who are each paid $120,000 in total compensation. During the accounting period, it also paid $8500 in total travel costs for the consultants to perform onsite client work. Therefore, company A's COS would look like this:
(10 x $120,000) + $8500 = $1,208,500
Company A's COS for this accounting period was around $1.2M.
For a slightly different situation, let's look at Company B. Company B provides high-end salon services, including hair and nail styling. It directly employs six stylists; each paid $70,000 in total compensation. While Company B is a service company, providing their Service requires materials such as styling gel and manicure supplies. During the accounting period, Company B also spent $10,000 on hair products and $3,300 on nail polish, which were used to provide customer services.
(6 x $70,000) + $10,000 + $3300 = $433,300
Company B's COS for this accounting period was around $433K.
COGS vs. OPEX
While at first glance they may seem similar, COGS and OPEX are two distinct concepts in bookkeeping. They indicate different types of costs and give you additional insights about your business.
As we've seen, COGS includes costs directly related to providing your product or Service. However, it does not include indirect costs for running the business rather than creating and delivering the product. Instead, these indirect costs are included in your operating expenses (OPEX). OPEX commonly includes marketing, office rent, administrative costs, and salaries for employees not directly involved in creating the product.
Many companies' OPEX will include costs like the following:
- Salaries and wages for employees not directly involved in building/delivering the product, such as sales reps, retail staff, marketing, HR, finance, and IT/ internal tech support.
- Rent for office or retail locations
- Utilities for office or retail locations
- Marketing costs such as advertising and promotions
- Insurance policies such as business insurance and workman's comp
- Software tools for administrative or marketing functions (CRM, HR platform, expense management, etc.)
- Fees for professional services such as contract bookkeepers or tax preparers
- Employee training and perks
- Office Supplies
- Business travel, except if required to deliver the Service onsite (ex: gasoline expenses)
Your company's OPEX amount tells you how efficient you are at running your company overall, not just in creating the product.
With COGS, you can track your business's efficiency, identify opportunities to lower your costs, and possibly even reduce your business taxes. The bottom line? Understanding your COGS is a crucial piece of the puzzle for understanding the overall health of your business.
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