By definition, COGS or cost of goods sold is the expense directly involved in production without covering other overheads. It is important to calculate COGS to set the prices and plan other expenses. Also, these numbers help in calculating the revenues generated by a business in a year.
The calculation of the cost of goods sold applies to companies with physical products with inventories. If you talk about an IT support company, usually this model does not apply to them. It is because software products or services cannot be accounted for in a business’s inventory. In this blog, you can see what the cost of goods sold is, how to calculate it, why it is important, and a lot more.
What Costs Are Included in COGS and What Aren’t?
As previously mentioned, COGS includes the costs “directly” involved in the production of products. In most cases, these are the costs of materials and labor. These two are essential to produce a product. But it is not always as simple as adding up the costs of hours of labor and the raw material. For example, if you have involved a third-party contractor for production, the model may require modifications based on the decided terms. So, if you have agreed to share a percentage of profit with your contractor, that can be added to the cost of goods sold.
From a broader perspective, you may think that the rent and maintenance of the production facility may be included in the production costs. The same applies to utilities like electricity. However, these costs are not included in the cost of goods sold. These expenses are termed operation expenses. All such costs come under a different umbrella. Even the sales and marketing expenditures are not added to COGS.
Lastly, even the moving expense and packaging required to move products from a company’s warehouse are exceptions from COGS. But on the other hand, if you are dealing in FMCG or a similar industry, things are different. The cost of packaging material and the labor involved in packing products for storing inventory does apply to the cost of goods sold. The reason for mentioning packaging and moving costs in both cases is to demonstrate two different cases.
How to Calculate the Costs of Goods Sold?
The straightforward method of calculating COGS is quite simple. You can use the following formula to do so:
COGS = Starting Inventory + Purchases During the Period – Ending Inventory
In this formula, the starting inventory is the cost of merchandise brought forward from the last year. These may be the products that have gone unsold during the previous or could be stocked from excessive production. In contrast, the ending inventory is the cost of products you are left with at the end of the year. So, these are the values you have to carefully consider.
Purchase during the period is the accumulated cost of raw materials, freight of bringing in the materials to the production facility, and your company’s warehouse. Again, these expenses are a part of the actual production costs. So, they all add are added to calculate the purchases during the period.
Why Is It Important to Calculate COGS?
It is important to calculate the cost of goods sold for the following reasons:
One of the reasons why you have to calculate the cost of goods sold is because you may have to show it in the income tax of your company. Companies that track records of the expenses that come under COGS can benefit from tax benefits. The more detailed and inclusive your cost of goods sold is, the better it is for your business in lowering the taxed amount.
Insights Into Profits
Besides benefits on applicable taxes, you also get insights into the gross profits your company makes. One of the most logical things you can see from COGS is whether your production costs are exceeding profits. Also, the lower cost of goods sold and more revenue is a green signal that can show positive growth. These insights may help you when it comes to getting the interest of investors and satisfying shareholders.
Future Decision Making
The cost of goods sold can also help you in the decision-making for the future. The data may help you bridge the current gaps in your business, like devising a strategy to lower production costs and maximize profits.
Understanding and tracking COGS can be helpful for your business in several ways. You can get valuable insights, tax benefits, and much more through this practice.