As a business owner, COGS (Cost of goods sold) is a concept you need to understand and know how to calculate or find in your financial statements. This financial metric directly impacts multiple aspects of your business, including gross margin and profitability, and helps you better assess your business performance.
We’ll take a real quick look at COGS to give you a general idea of the concept and its importance for a business.
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What is the Cost of Goods Sold (COGS)?
Cost of goods sold (COGS) is an accounting term that refers to the direct cost attributed to the production of goods or services sold by a company, including raw materials, labor, and other expenses incurred in producing the final product or service. COGS is an important measure of profitability for businesses as it directly affects the calculation of gross profit margin.
COGS: Direct and indirect costs
Direct costs are basically the expenses directly linked to creating a product or service. Think of things like shipping, storage, and buying the raw materials or parts you need. Keeping an eye on these costs can help you predict future inventory needs. For example, if your raw materials start running low, it’s often a sign that you’ll need to ramp up production soon.
Indirect costs are the expenses that aren’t directly connected to making a specific product or service. These costs cover the things that keep the overall operation running smoothly, but aren’t tied to one particular item. For example, this includes things like warehouse utilities, distribution costs, and the equipment used in production. They’re essential for the business, but not linked to any single product.
How does COGS impact finances?
COGS has a significant impact on a company’s financial performance. Here’s how COGS affects a company’s finances:
Gross margin
COGS is a crucial component in calculating gross margin. Gross margin is the percentage of revenue that remains after deducting COGS. A high gross margin is desirable as it indicates that a company is generating more revenue than it’s spending on producing the product. A low gross margin can raise concerns about a company’s profitability.
Profitability
COGS directly impacts a company’s profitability. As COGS increases, the profit margins decrease. This means that a company needs to sell more products or services to generate the same level of profit.
Pricing strategy
COGS plays an essential role in determining the pricing strategy of a company. A company must ensure that the price of its product or service covers the cost of production and generates an adequate profit margin.
Inventory management
COGS also affects a company’s inventory management. If COGS decreases, a company might reduce its inventory levels and free up cash flow. On the other hand, if COGS increases, the company may need to order more inventory to maintain the same level of production.
What type of account is COGS?
In accounting, cogs (cost of goods sold) is classified as an expense. It represents the direct costs incurred in producing goods or services that a company sells to generate revenue. COGS includes the cost of materials, labor, and other expenses directly involved in the production process. It is usually reported on the income statement as a separate line item below revenue and above gross profit. The calculation of COGS is an essential part of determining a company’s profitability and its ability to manage its costs effectively.
In accounting, GOGS (Cost of goods sold) is classified as an expense. It is usually reported on the income statement as a separate line item below revenue and above gross profit.
COGS appears on the income statement as an expense that is incurred when producing and selling a product, such as the cost of all the materials and direct labor. However, it does not include indirect costs such as rent, utilities, and indirect labor costs.
When calculating COGS, one needs to use accurate data because it is a significant factor in determining a company’s profitability. For example, COGS is subtracted from the company’s revenue to get its gross profit margin. COGS is also necessary for calculating inventory turnover ratios that measure a company’s efficiency in managing its inventory.
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How to calculate COGS in accounting
So, let’s look at how to calculate your COGS. It’s worth saying that specific figures and elements of the formula might depend on the type of business you’re running or the location, and as such, we’ll be providing some general steps typically involved in calculating COGS (whenever you need accurate calculations, you might want to turn to an accountant for professional help):
1. Determine the starting inventory value. It’s the cost of the inventory you had on hand at the beginning of the accounting period.
2. Add inventory purchases. Add the cost of all the inventory you purchased during the period.
3. Subtract ending inventory value. It’s the cost of the inventory that remains unsold at the end of the accounting period.
4. The result is your COGS: the figure represents the cost of the inventory sold during the accounting period.
In this article, we’re just touching upon the topic of COGS. You can find more in-depth information on the matter in the suggested articles below:
- How to Calculate Cost of Goods Sold: Formula and Useful Example to Help You Calculate COGS
- What is COGS in Business and Accounting? How to Calculate It: Examples and Formula
What is the Cost of Sales and why does it matter for your business?
Cost of sales, or cost of revenue, represents the total expenses a business incurs to produce a product or service. Like COGS (cost of goods sold), it includes all direct costs associated with production. If the cost of sales rises while revenue stays flat, it can signal increasing input costs or inefficient expense management.
Cost of Goods Sold vs. Cost of Sales
While often used interchangeably, COGS and cost of sales have key differences:
Tax Deduction: COGS is tax-deductible, lowering taxable income, while cost of sales is not.
Analysis: Cost of sales includes both direct and indirect costs, while COGS focuses only on direct production costs.
Income Statement: Cost of sales appears before EBIT, whereas COGS is listed after revenue.
Amount: Cost of sales is usually higher as it includes more expenses.
Conclusion: COGS in Accounting
Cost of goods sold (COGS) is an accounting concept businesses need to understand to keep their finances in order. COGS has a significant impact on a company’s financial performance, profitability, pricing strategy, and inventory management. Knowing the basics of COGS is essential to help businesses make informed decisions about their products and services. Companies need to monitor their COGS closely to optimize their financial performance.
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