The cost of goods sold, or "COGS" for short, is a measurement of the direct costs associated with selling products. The costs included in this calculation have to be directly tied to the inventory sold, as opposed to general operational expenses.
Learn how to calculate it and how accounting methods can affect your results.
What Is the Cost of Goods Sold?
The cost of goods sold is an equation that gives businesses a sense of merchandise's "true cost." As the name implies, it measures how much it costs a business to sell a product. However, this figure doesn't include all the costs that go into running a business.
The Internal Revenue Service (IRS) lists four costs that can be included in a COGS calculation:
- The cost of products or raw materials (including freight/shipping costs)
- Direct labor costs (including contributions to pensions or annuity plans) for workers that produce the products
- Factory overhead
The cost of goods sold is a crucial figure for businesses that want to calculate their gross profit—simply subtract COGS from revenue. You can also find the gross margin by dividing the gross profit by revenue.
How Do You Calculate the Cost of Goods Sold?
To calculate the cost of goods sold, you first have to pick a period of time to measure. Let's say you decide to measure the cost of goods sold in the past month. In that case, you'd start with the total value of your inventory at the beginning of the month (remember to include direct costs in that value, such as shipping, storage, and raw materials), add any additional inventory purchases throughout the month, and then subtract the remaining inventory at the end of the month.
How the Cost of Goods Sold Works
The cost of goods sold is a good measurement of efficiency, especially when comparing two retail stores in a similar industry. Retail businesses often acquire inventory in a shelf-ready state, so there won't be variations in manufacturing or raw material costs between two retail stores. That allows analysts to focus on the costs can retail businesses can control, such as shipping costs and inventory levels.
Properly managing inventory is the key to successful retailing. It is an incredible balancing act that is equal parts of art and science.
Too Much Inventory Leads to Cash Flow Problems
If the income statement (otherwise known as the P&L) shows that a retailer made money last month, yet their bank account shows they are losing money, the main reason for this is cash flow. When you buy an item for your inventory, it will have a period of time (known as dating) that you have to pay the vendor for it. The best retailers sell (turn) their inventory before the payment is due. However, this is very hard to do.
The problem with the P&L is that it shows you what happened during that month. However, it does not show you what happened the month before when you bought the shoes that now need to be paid this month. Cash flow problems happen when retailers fail to account for their payables in their sales planning. Be careful not to get seduced by a "great" offer from a vendor only to have to pay for it later.
Too Little Inventory Leads to Sales Problems
A retailer who is out of stock on items risks losing customers. Many retailers are so afraid of this that they overbuy and have lots of "extras" just in case. But that gets them into the cash flow problems we just discussed. So how do you manage this dilemma?
One of the best tools you can use to manage inventory is an open-to-buy system. This process helps you buy only the merchandise you need. It uses COGS and inventory turns to determine how much more inventory you need compared to what your sales trends have been.
Another great idea is to buy "at once" merchandise for your store. This is merchandise the vendor stocks in its warehouse for immediate shipment.
For example, if you can order a shoe and get it into your store within five days, there is no need to carry 10 of them. You just need enough to get you through the five days.
Limitations of the Costs of Goods Sold
One issue with the cost of goods sold formula is that it's broad, and it leaves a lot up to each business to decide how to calculate the direct costs associated with inventory. Failing to calculate those direct costs correctly can result in an inaccurate COGS result—it can either inflate or deflate your answer.
Beyond deciding what counts as a direct cost, inventory accounting methods also vary, which adds another layer of inconsistency to COGS. A single business can have multiple COGS calculations for the same period depending on how the inventory costs are calculated. There are four main types of inventory calculation methods, though many use either FIFO or LIFO. Here's how they work:
- FIFO, or “first-in-first-out,” assumes that the oldest units of inventory are always sold first. Costs in the COGS calculation will be assessed as the direct costs tied to the oldest inventory.
- LIFO or “last-in-first-out,” assumes the opposite—the last one to come in is the first one to go out. The most recent direct costs are used in the formula.
- Weighted average accounting methods don't look at any specific costs for inventory and instead averages out all the costs with all the goods sold and available for sale.
- Specific identification, as the name implies, specifically identifies each inventory cost, so it only works best for businesses like car manufacturers or real estate developers.
- The cost of goods sold (COGS) calculates the direct costs tied to selling inventory.
- The IRS says the COGS can include expenses tied to products and raw materials, storage, direct labor costs for workers who produce the products, and factory overhead.
- COGS figures can fluctuate significantly depending on a business's accounting methods.