Understanding the Cost of Goods Sold (COGS) is crucial for businesses that deal with physical products. By using a simple formula – opening inventory plus purchases and production costs, minus closing inventory – you can determine how much it costs to produce a saleable item. This figure is essential for evaluating profitability, both at the product level and across your entire business.
In this article, we’ll break down what COGS is, why it’s vital for product-based businesses, and how to calculate it using the cost of goods sold formula.
What is cost of goods sold?
Cost of goods sold (COGS) refers to the cost of producing or purchasing a product that is sold by a business. It’s an important inventory accounting metric for any company selling physical goods as it directly impacts profit margins and product pricing.
What’s included in cost of goods sold?
Cost of goods sold includes:
- Direct materials: Raw materials used in production (e.g., wood, plastic).
- Direct labor: Wages for staff involved in production (e.g., factory workers).
- Manufacturing costs: Overheads like factory rent, equipment, and maintenance.
COGS excludes indirect costs like marketing, administration, and taxes.
It’s possible to reduce Cost of Goods Sold by buying in bulk or when a discount is available, negotiating with or changing suppliers, and sourcing cheaper labour.
How to calculate cost of goods sold: The formula
You can calculate COGS using the formula:
Beginning Inventory + Purchases and Production Costs – Ending Inventory = Cost of Goods Sold
You might be thinking, it’s all good and fine to have a formula for COGS but how do I determine the data inputs needed to make it work?
Don’t worry, we’ve got you covered.
The inputs you need to calculate the COGS formula:
- Beginning Inventory: The value of the inventory you have at the start of the period.
- Purchase Cost: The total cost of additional products or raw materials purchased during the period.
- Ending Inventory: The value of the inventory you still have at the end of the period.
How to use the COGS formula
To utilise the COGS formula, you’ll first need to decide on your cost of goods sold ‘period’. Often the assessment is made over a year, but it depends on your business and the solutions you may be trying to find.
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Determine the period: Choose the time frame for your COGS calculation. This refers to the inventory in the warehouse at the time the period starts.
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Assess opening inventory: Calculate the value of the inventory at the start of the period. This could include the number of boxes containing goods and the number of raw materials and products being held.
- Calculate closing inventory: At the end of the period, assess your closing inventory using the same method as for the opening inventory. This allows you to track changes over time.
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Account for purchases and production costs: Consider the purchases you’ve made, and the production costs you’ve incurred throughout the period. This could include raw materials, direct labour, and manufacturing overheads directly attributable to the relevant inventory
- Use the COGS formula: Once you’ve gathered all the necessary data, plug it into the formula to calculate your cost of goods sold
Valuing your inventory to Cost of goods sold formula in accounting ensure the accuracy of COGS
Different accounting treatments can also yield different results of running the cost of goods sold formula.
The three most common inventory valuation methods used with COGS:
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The FIFO accounting method: First-In, First-Out (FIFO) assumes the items purchased or produced first are also the first to be sold.
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The LIFO accounting method: Last-In, First-Out (LIFO) assumes the items purchased or produced first are the last to be sold.
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The average cost method: Unlike FIFO and LIFO, this method takes the average prices of the various goods that are in stock, without considering the purchase date of those goods.
Using the average cost methodology, the COGS calculation is smoothed out over that time. This means that spikes or drops in demand and purchasing costs do not have an unjustifiable significant impact on the final figures.
Cost of goods sold journal entry (with examples)
Inventory accounting journal entries for cost of goods sold generally require debiting the COGS and crediting the inventory account.
It’s important to ensure the accounting is consistent across various entries, and that you’ve used the right formula to assess the cost of your business.
Generally, a journal entry will look something like this:
- Date of the transaction
- Debit: The cost of goods sold
- Credit: Inventory
- Credit: Purchases
We’ve outlined a couple of examples below:
COGS journal entry: Example 1
On December 6 last year, the balance of your opening inventory was $8,500. This consists of caps, T-shirts, and tracksuit pants.
Through the COGS period, you purchase wool and cotton to make more items, along with additional items such as elastic and pre-made logos. You also pay for labour to create the products. The cost of all this is $3,000.
At the end of your six-month COGS period, you have $2,350 of closing inventory.
Your cost of goods sold journal entry would look like this:
| Account | Debit | Credit |
| Cost of Goods Sold | 9150 | |
| Inventory | 6150 | |
| Purchases | 3000 | |
| Total | 9150 | 9150 |
COGS journal entry: Example 2
On Jan 18 this year the balance of your opening inventory was 50 designer light shades, each worth $2,000. Your opening inventory is therefore $100,000.
Over the next three months, you purchase 5 more of the same light shades, so your cost over this time is $10,000. You then sell 10, so your closing inventory is $90,000.
Your cost of goods sold journal entry would look like this:
| Account | Debit | Credit |
| Cost of Goods Sold | 20000 | |
| Inventory | 10000 | |
| Purchases | 10000 | |
| Total | 20000 | 20000 |
There are likely additional costs you will need to journal to get a full picture of your costs, revenue, and profits. Separate accounting lines will be used for these, and they will be debited or credited as suits your accounting system and business structures.
Cost of Goods Sold Calculator
Use our handy cost of goods sold calculator below to determine your COGS. You can then use the lower half of the calculator to determine your average inventory and inventory turnover for the same period:
COGS = the starting inventory + purchases – ending inventory.
For more formulas please visit the Inventory formulas & live inventory calculators page.
Why is the cost of goods sold formula important?
The COGS formula is important because it determines the direct costs of producing a certain number of goods during an identified period. This allows business managers or owners to make important financial calculations, such as understanding the gross profit and cost of inventory during that period.
Cost of goods sold is also an important figure for auditing purposes because it offers transparency over cost and earnings.
The COGS formula is used extensively throughout business, particularly when there are large amounts of inventory moving through a supply chain and onto the customer.
Benefits of using the cost of goods sold formula
Some of the core benefits of using the cost of goods formula include:
- The ability to assess your gross profit and understand the potential profitability of your business.
- The insights gained into the production costs and the ability to see where costs may be lowered, or other savings made.
- The clarity around which products may be more expensive than others to produce.
- The ability to understand the ebbs and flows of costs and if those can be managed in a way that is beneficial to the business.
Cost of goods sold is a widely recognised way of assessing costs associated with manufacturing products. But there are variances in how it is handled, which means it can be prone to errors, miscalculations, and inconsistencies.
Risks of using the cost of goods sold formula
The COGS formula only takes direct costs into account. Any indirect costs, such as administrative and office costs, marketing and advertising, and rental expenses are not captured by the formula.
Expenses must be categorised appropriately and consistently every time a COGS analysis is done. Otherwise, the results can be badly skewed.
Best-practice tips for using the COGS formula:
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Use the same accounting system across the business so that when the full financial statements are done, the figures have all been assessed from the same baselines.
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Calculate comparative points in time – such as when opening inventory and closing inventory – that have the same underlying assumptions.
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Make sure the calculations are well recorded in time for the next COGS period. This ensures any variances in profits or losses over those periods can be compared.
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Any direct raw materials, such as buttons and thread, that are used to create a final product must be included in your cost of goods sold calculations.
Cost of goods sold formula in accounting
Different accounting treatments can also yield different results of running the cost of goods sold formula.
The three most common inventory valuation methods used with COGS are:
- The FIFO accounting method: First-In, First-Out (FIFO) assumes the items purchased or produced first are also the first to be sold.
- The LIFO accounting method: Last-In, First-Out (LIFO) assumes the items purchased or produced first are the last to be sold.
- The average cost method: Unlike FIFO and LIFO, this method takes the average prices of the various goods that are in stock, without considering the purchase date of those goods.
Using the average cost methodology, the COGS calculation is smoothed out over that time. This means that spikes or drops in demand and purchasing costs do not have an unjustifiable significant impact on the final figures.
Frequently Asked Questions
Is cost of goods sold an expense?
Cost of goods sold is considered an expense for accounting purposes. This is because it represents direct costs incurred in the production or purchases of goods during the accounting period.
COGS is included in the financial statement as a line item because it’s directly responsible for generating information about the business’s costs and profits. However, COGS is different from other operating expenses such as marketing, office, or overhead costs.
What is cost of sales vs cost of goods sold?
Cost of Sales and Cost of Goods Sold are often used interchangeably because they both reference the direct costs associated with producing or purchasing goods that are sold. However, they’re not always the same thing.
The main difference between COGS and cost of sales is that COGS refers to the cost of making a product, while cost of sales refers to the cost of a product which has been sold.
This means:
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Manufacturers generally refer to the COGS because they can tie specific costs back to the production of tangible goods, such as labour, raw materials, and machinery used.
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Service-only businesses generally lean toward the cost of sales because it is more difficult to assess the direct costs of a sale made.
Overall, the two terms are very similar as they’re used to reflect the cost of providing a service or goods, which is ultimately used to understand costs, revenues, and profit.
What is the formula for gross profit and COGS?
The formula for gross profit is:
Gross Profit = Revenue − COGS
This shows how much you earn after covering the cost of producing your products.
What is the formula for COGS ratio?
The COGS ratio is calculated as:
COGS Ratio =COGS/Revenue
This ratio helps measure what percentage of your revenue is used to cover production costs.
