KPI is an abbreviation known to any savvy business owner who wants to keep their finger on the pulse of their company. KPIs allow you to keep track of your company’s progresses and failures and invest more time and effort where it’s required.
According to Luis Mocsa, a certified public accountant, owner of several small businesses and a consultant with American Management Services, KPIs are both strong and versatile. A KPI is a guide that helps to achieve business success by evaluating employee productivity, measuring your finances to the status of a job in progress. Key performance indicators change depending on the goals of your business, projects and timelines, which means that business KPIs shift over time. Being versatile, KPIs fall into various categories. This article will focus on one of the financial KPIs, namely cost of goods sold or COGS and cover the following points:
What is COGS?
Cost of goods sold (COGS) is an essential metric for any business which reflects the direct costs of producing the goods sold by the business. According to the cost of goods sold definition, this metric includes the cost of the materials and labor directly used to create the product and excludes indirect expenses like distribution and sales force costs. Cost of goods sold is sometimes called “cost of sales.”
COGS is also an accounting term under U.S. Generally Accepted Accounting Principles (GAAP) that requires businesses to apply certain inventory costing principles. GAAP provides guidelines about which costs are to be included or excluded in the process of COGS calculation.
How does COGS work?
Why is COGS important?
The importance of COGS is explained by its direct connection to the gross profit of the company, which is calculated by subtracting COGS from a company’s revenues. Gross profit is a key indicator of a company’s profitability which measures how effectively a company uses its resources while producing goods or services. Let’s leave the formula for gross profit calculation here:
|Gross profit=Revenue-Cost of Goods Sold|
COGS is also a key component in determining a company’s gross margin, which is calculated by subtracting COGS from a company’s net sales. Gross margin is the amount of money a company keeps after incurring the direct costs needed for creating the goods it sells and the services it provides. The formula for gross margin calculation is:
|Gross Margin=Net Sales− Cost of Goods Sold|
COGS is an essential component of determining two critical business metrics: a company’s gross profit and gross margin.
COGS is included in business expenses on the income statement. Increasing COGS means decreasing net income which is beneficial for income tax purposes but means less profit for the shareholders. Based on that, businesses try to keep their COGS low and their net income high.
What does COGS consist of?
In the process of product or service creation all companies incur certain costs like material, labor, building rentals and utilities which make up some part of the final price of a product. It should be mentioned once again that the cost of goods sold includes only the direct costs paid by a business to produce the goods or services that were sold during the period while excluding indirect costs like overhead, sales and marketing. Manufacturing overhead is part of COGS, though. It’s necessary to stress the fact that the cost of goods sold doesn’t include the expenses sustained to make the products that have not yet been sold. Thus, only the cost of the products that have been successfully sold is taken into account.
A simple example of COGS components
If you buy a pair of shoes for $100, part of this price is contributed by COGS. In the case with shoes, COGS will include the cost of material, labor to make the shoes, sewing equipment and electricity to run it. The costs of transportation, accounting services, advertising and selling of the shoes aren’t part of COGS.
GAAP for COGS
Now, if we turn to GAAP, defining COGS components may not be that easy. GAAP guidelines help to account for operating expenses. Under GAAP, all operating expenses must be registered on a company’s books. However, there are no direct and specific instructions on how to categorize some expenses. That means that two companies may account for the same expense differently and both of them might still be in compliance with GAAP. Let’s look closer at the way it works.
Business expenses and some examples of COGS components
COGS/COS and SG&A represent different categories of expenses.
COGS or COS (cost of services, a term that works for service companies) stands for all the costs directly associated with producing a product or delivering a service.
SG&A is a part of operating expenses and stands for selling, general, and administrative expenses.
It’s up to the accounting department of a company to decide what should be included in COGS or COS and what shouldn’t. This seems easy in theory, but in practice the situation is a bit more complicated.
It has to be mentioned that service companies can’t list COGS on the income statement. They have COS instead, but it doesn’t count as COGS deduction.
In some situations the decision is obvious: for example, the cost of the fabric/material for the shoes (mentioned in the example before), the wages of the people making them are directly related to the final product for sale, so they go into the cost of goods sold. There’s no doubt here as COGS by definition includes direct labor costs and any direct material costs associated with the production process. On the contrary, the salary of the human resources manager and the cost of supplies used by the sales department go into SG&A, not in COGS or COS.
But this is where black and white definitions end and we enter the gray area. Where do we put the salary of managers of the shoe factory or the quality supervisors? GAAP doesn’t say “yes” to one and “no” to the other. So companies use GAAP guidelines and logical approaches and apply them according to their particular situations. The key moment here is to apply these guidelines logically and consistently.
Cost of Goods Sold formula and calculation
Now let’s turn to the formula for COGS calculation.
|Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold|
It’s necessary to clarify what we call inventory as there are different inventory costing methods that will be looked into later in the article.
The term “inventory” refers to the goods and materials that a business holds for the ultimate goal of resale, production or utilization. Inventory is one of the most important assets and consists of three components:
- raw materials
- production in progress
- final goods for sale
Inventory is reflected on the company’s balance sheet under the category current assets account. The balance sheet gives information about the state of a business at the end of an accounting period, and the inventory value recorded there is the closing inventory cost. If we look at the beginning inventory, it’s basically the inventory that wasn’t sold during the previous year. Everything that is manufactured and purchased during the year by a manufacturing or retail company is added to the beginning inventory. The products that weren’t sold by the end of the year (ending or closing inventory) are subtracted from the amount we get after adding up beginning inventory and purchases. The result is the COGS of the year. The formula seems rather straight-forward.
Inventory costing methods and Cost of Goods Sold calculation
The cost of goods sold calculation depends on the inventory costing method practiced by the accounting department of a company. Three most popular inventory costing methods are:
This method assumes that the earliest manufactured or purchased goods are sold first. So if we have in mind growing prices, the company that adopted the FIFO method sells the cheapest products first. The cheapest inventory items sold lead to a lower cost of goods sold and a higher net income over a period of time. There are some advantages of FIFO that should be mentioned here:
- FIFO is the most universal and widely used method of inventory evaluation.
- FIFO reduces the impact of inflation
- FIFO minimizes obsolete inventory
- FIFO gives a more accurate picture of inventory costs
On the contrary, LIFO means selling the latest and the most expensive goods on the inventory first. That leads to a net income decrease and consequently a higher COGS. Here are some peculiarities of the method:
- LIFO is used only in the United States under GAAP
- Using LIFO is tax advantageous during a period of rising prices
- Companies practicing LIFO normally have large inventories like retailers and car dealers
- LIFO lowers net income during a period of rising prices, which isn’t beneficial when reporting the financial results
3. Average Cost Method or Weighted Average Cost (WAC)
Average cost method, as prompted by the name, represents the golden medium. The value of the goods in stock is calculated with the help of the average price over a period of time, regardless of the purchase date. This method helps to level out COGS and net income fluctuation when prices of the goods change significantly.
Summing up, all the mentioned inventory costing methods bring the same results with zero inflation. With high inflation, inventory costing method choice can significantly change the numbers.
E-commerce solutions and COGS
The changeable world of e-commerce requires a solid combination of global business management knowledge and business software programs. This combination allows you to analyze your business data with the help of a reliable software solution tracking your business metrics, business management CRM platforms following your client data, and accounting software simplifying your accounting procedures.
We see the world of professional services automation unfolding now, so it’s high time to jump on the bandwagon and take your business to the next level. Synder Insights is e-commerce business intelligence software that can help your business grow strategically. Synder Insights is a tool that contains your business data and gives you access to reports with explanations of how the insight of these reports might scale your business. Reliable information takes the guessing game out of everyday decision making and boosts your business growth.
When it comes to the Cost of Goods Sold calculation, Synder Insights is the simplest solution as it boasts the following features:
- Hourly multichannel data imports
- Sales analytics
- Product and COGS analytics
- Customer cohort reports
- Cross platform e-commerce KPIs
Synder Insights helps to accumulate, analyze and visualize your business data. This is how it looks with the COGS example.
Calculating and analyzing COGS might be tricky sometimes. Regardless of the inventory costing method, it has to be consistent and precise, which requires a lot of effort, but with the right accounting and inventory software it becomes a matter of one click. The most beautiful thing is that Synder Insights is so simple and intuitive that you can easily analyze the data. It’s designed to create a better customer experience. So give Synder a try for yourself! You can also book a demo.