Understanding cost of goods sold (COGS) is important for businesses determining their net income for a certain period. Including all costs directly related to producing goods, this information provides businesses a clear understanding of the expenses integral to powering their business operations.
Excluding indirect expenses, this popular cost metric primarily accounts for the cost of materials and labor directly used in the creation of a good. This is often found on financial statements of companies, where it is used to illustrate the gross profit of a business.
For those wondering “What is cost of goods sold?”, this article will explain the cost of goods sold definition and illustrate the cost of goods sold formula, how to calculate cost of goods sold, and provide examples of where it can be found on a company’s financial statements.
Cost of Goods Sold Definition
A key metric found on financial statements; the cost of goods sold definition is the expenses directly associated with the production of goods. Indirect expenses, such as overhead, distribution, or advertising costs, are not included in the amount. Also known as the “cost of sales,” this value can be measured differently depending on the accounting standards utilized in its calculation.
Considered the cost of doing business, this critical value is always recorded as a business expense on a company’s income statement and is important in identifying a company’s bottom line. This value is incorporated into gross profit calculations and therefore influences the product of the net income formula.
What is Cost of Goods Sold
Cost of Goods Sold Formula
Cost of goods sold is calculated by adding the value of a company’s beginning inventory to any purchases of inventory made during the period. The sum of these values is then subtracted from the company’s ending inventory for the period. A consistent approach to valuing inventory and costs must be used in the cost of goods sold formula.
Cost of Goods Sold (COGS) = Beginning Inventory + Purchases – Ending Inventory
Where:
Beginning Inventory = value of inventory present at the start of the period
Purchases = cost of additional inventory produced or purchased over the period
Ending Inventory = value of inventory left by the end of the period
How to Calculate Cost of Goods Sold
Calculate Step by Step
- Determine the values of the beginning and ending inventory for a period.
- Determine the amount of additional production or purchases of inventory made in the period.
- Add the value of the beginning inventory to the cost of any production or purchases.
- Subtract the value of the ending inventory from the sum of Step 2.
Example
A manufacturing company is determining its cost of goods sold for the year in preparation for a meeting with shareholders. Based on their business operations for the year, the company has determined the following values:
Value of Inventory at the start of the period: $20,000
Value of inventory at the end of the period: $8,000
Cost to Purchase and Produce Inventory: $50,000
Given this information, it can be determined that the beginning inventory is $20,000, the value of purchases is $50,000, and the ending inventory is $8,000. The company can now populate the cost of goods formula and solve for the consolidated costs from sales as follows:
COGS = Beginning Inventory + Purchases – Ending Inventory
COGS = $20,000 + $50,000 – $8,000
COGS = $70,000 – $8,000
COGS = $62,000
Here we can see that the manufacturing company’s cost of goods sold for the year is $62,000. This value represents all of the direct costs attributable to the production of goods in inventory, such as direct material and direct labor costs.
With this information, the company can now determine their gross profit and net income, allowing them to illustrate to shareholders and company executives what the bottom line of the company is.
Tips for Calculating
Tip Number 1:
There are four major accounting methods used to measure these types of costs: First In, First out (FIFO), Last In, First Out (LIFO), the Average Cost Method, and the Special Identification Method. Each accounting standard uses a different baseline to measure the direct costs accrued. Certain accounting standards of measurement are more suitable for certain industries, so businesses must carefully decide which standard of accounting they will use for the cost of goods sold formula.
Tip Number 2:
Cost of goods sold does not apply to pure service companies which produce no tangible goods, such as law firms, consulting agencies, or marketing offices. Service companies instead calculate their cost of services, which has a different formula. When applying the cost of goods formula, make sure the business produces goods for inventory and sale – otherwise the formula will not accurately reflect the company’s true cost of sale expenses.
Tip Number 3:
For certain companies or certain goods, determining the direct expenses which fall under this category of costs is difficult. Direct material and direct labor costs are not always clear, and other costs can be incurred as a result of the production of goods. A common rule of thumb for determining if an expense is a sales related cost is by asking, “Would this cost have been an expense if no sales were generated?” This will help you determine if a cost is a result of the sale of a good.
Financial Statements
Cost of goods sold is a metric commonly found on the top of the income statement for companies which produce, purchase, or otherwise manufacture goods. For investors and company managers alike, this value is a critical component for determining the profitability of a company.
Being able to locate the cost of goods sold on an income statement is important. In this example, we will review the income statement for American Outdoor Brands, Inc. (AOUT), which is a manufacturer of various outdoor sports and recreation products within the United States.
Note: All numbers in this income statement are measured in thousands.
As shown in American Outdoor Brands’ income statement, the cost of goods sold (which is noted as the “cost of revenue”) by April 30, 2021 was 149,859. Since this income statement is measured in thousands, this means the true cost is $149,859,000.
As displayed in the income statement, investors can compare multiple periods to show that the identified cost of revenue for American Outdoor Brands has increased every year. This increase could be due to higher sales volume, increase in the costs of production, or alterations to the company’s accounting standards of measurement.
Decreasing gross profits can also be attributable to the cost of sales increasing for a company. This information significantly assists investors and company executives in determining the profitability of the company.
Takeaways
Cost of goods sold encompasses all costs directly attributable to the production of a good. This is calculated by adding the value of beginning inventory to purchases made during the period and subtracting the value of ending inventory from this sum.
Cost of goods sold is measured in terms of currency. A consistent accounting method, such as FIFO, LIFO, the Average Cost Method, or the Special Identification Method, should be used to account for the expenses included in the final amount.
