May 10, 2023
Definition of Cost of Goods Sold (COGS)
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Cost of Goods Sold (COGS) is a critical metric that every business owner needs to understand. It is the total cost of producing and selling a product, including the cost of materials, labor, and overhead. COGS is essential for assessing profitability, developing pricing strategies, and controlling costs. In this blog post, we will explore the definition of COGS, explain why it matters, its limitations and provide an overview of how to calculate it.
Definition of COGS
COGS is the direct cost of producing and selling a product. It includes the cost of all the materials, labor, and overhead that go into making the product.
Examples of expenses included in COGS include:
Direct materials: the cost of raw materials used in production, such as wood, metal, or plastic.
Direct labor: the cost of wages, salaries, and benefits for workers involved in production, such as assembly line workers, machinists, or technicians.
Manufacturing overhead: Rent of the production premises, repairs or maintenance, or property taxes
Expenses that are not included in COGS include:
Marketing and advertising expenses: the cost of promoting and selling the product.
General and administrative expenses: the cost of running the business, such as office rent or salaries for non-production staff.
Research and development expenses: the cost of designing and testing new products or improving existing ones.
It is important to note that while some expenses are not included in COGS, they are still important to track and analyze for the overall financial health of the business.
Why COGS Matters
Tracking COGS is critical for several reasons:
Determining profitability: By subtracting COGS from revenue, businesses can determine their gross profit margin. Gross profit margin is a key metric for assessing profitability, as it indicates how much money is left over after direct costs are accounted for. It is essential to maintain a healthy gross profit margin to ensure the long-term sustainability of the business.
Pricing and sales strategies: Understanding COGS can help businesses set prices and develop sales strategies that ensure they make a profit on each sale. By calculating the cost of producing and selling each product, businesses can set a price that covers their costs and generates a profit. Additionally, tracking COGS can help businesses identify which products are most profitable and which may need to be discontinued.
Cost control: Tracking COGS can help businesses identify areas where they can reduce costs and increase efficiency. By analyzing the direct costs of production, businesses can identify ways to streamline their operations, reduce waste, and optimize their supply chain. This can help them reduce their overall costs and improve their bottom line.
To calculate COGS, you need to know the cost of the inventory sold during a specific period. The formula for calculating COGS is:
Starting Inventory + Purchases - Ending Inventory = COGS
To determine the cost of inventory, you can use one of several accounting methods:
FIFO (first-in, first-out): Assumes that the first items purchased are the first items sold.
LIFO (last-in, first-out): Assumes that the last items purchased are the first items sold.
Average cost method: Calculates the average cost of all items in inventory.
Special identification method: Identifies and tracks the cost of specific items in inventory.
It's important to note that different accounting methods can result in different COGS calculations, which can impact profitability and financial reporting.
Are Salaries Included in COGS?
Salaries for production workers are typically included in COGS, as they are considered a direct cost of producing the product. However, salaries for managers and administrative staff are not typically included in COGS, as they are not directly involved in production.
How Does Inventory Affect COGS?
If the cost of inventory increases, so does COGS. Conversely, if the cost of inventory decreases, COGS decreases as well. This can impact profitability and financial reporting, as well as pricing and sales strategies.
Cost of Revenue vs. COGS
Cost of revenue includes all expenses related to producing and selling a product, including COGS as well as other expenses such as marketing and advertising. COGS is a subset of cost of revenue. While cost of revenue is a broader metric that includes all expenses related to selling a product, COGS is a more specific metric that provides insight into the direct costs of production.
Operating Expenses vs. COGS
Operating expenses are all expenses not included in COGS or cost of revenue, including general and administrative expenses, research and development expenses, and selling expenses. Operating expenses are important to track and analyze, as they impact the overall financial health of the business. By analyzing operating expenses and identifying areas where costs can be reduced or controlled, businesses can improve their profitability and sustainability.
Limitations of COGS
While COGS is a critical metric for businesses to track, it does have some limitations. For example, COGS does not take into account changes in pricing or volume discounts that can affect profitability. Additionally, different accounting methods can result in different COGS calculations, making it difficult to compare the financial performance of different companies. It is important to use COGS in conjunction with other financial metrics and to carefully consider the limitations of the data when making strategic decisions.
COGS as it relates to the Small Business Owner
As a small business owner, understanding COGS is crucial for financial planning and optimizing profitability. COGS is a line item on the income statement and represents the direct costs associated with producing and selling a product. COGS includes material costs, direct labor costs, and manufacturing overhead costs, such as factory overhead. By tracking COGS, small business owners can accurately determine the true cost of sales and assess the financial performance of their business.
Small business owners can use different inventory valuation methods to determine the value of their inventory at the end of the accounting period. This information can then be used to assess the financial performance of the business using the cost of goods sold formula previously shown.
COGS can also impact the sale of a business. When a small business owner decides to sell their business, potential buyers will analyze the financial statements, including the balance sheet and income statement. By accurately tracking COGS and other operating expenses, small business owners can present a more accurate and appealing financial picture to potential buyers. This can help increase the value of the business and potentially lead to a more successful sale.
COGS is a critical metric for small business owners to track and understand. By accurately tracking COGS and other financial metrics, small business owners can optimize their profitability and present a more appealing financial picture to potential buyers. Additionally, understanding COGS is essential for complying with accounting standards such as GAAP and IRS regulations, and for maintaining accurate financial records and cash flow management.
In conclusion, COGS is a fundamental metric for businesses to track in order to assess profitability, develop pricing and sales strategies, and identify areas for cost control. COGS represents the direct costs of producing and selling a product, and it is critical for accurate financial reporting. By understanding the definition of COGS, how to calculate it, and its limitations, businesses can make informed decisions and achieve long-term success. As a beacon of financial health, COGS can help guide businesses to profitability and success. So, keep a close eye on your COGS and use it to inform your decisions as you navigate the world of business.
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Sam is an exit planning expert, combining years of experience working with small business owners with extensive knowledge of traditional and SBA financing.
Information posted on this page is not intended to be, and should not be construed as tax, legal, investment or accounting advice. You should consult your own tax, legal, investment and accounting advisors before engaging in any transaction.