Guide

Understanding and calculating Cost of Goods Sold (COGS)

What cost of goods sold is, how to calculate it and why it's important for your business.

What is COGS?

COGS is the direct cost to produce or purchase the goods you sell, or the materials you turn into goods.

COGS includes:

• Direct materials
• Direct labour

Some businesses, like ecommerce businesses, also include things like freight, storage, sales commissions, or transaction fees if they relate to the costs of selling products.

COGS doesn’t include indirect expenses, such as rent, marketing, general administrative overhead, and (often) salaries.

How to calculate COGS

There are two ways to calculate COGS – one more commonly used by retailers, the other by manufacturers.

Retail COGS formula

Cost of goods sold formula used by retailers for inventory accounting.

Where:

• Beginning inventory is the value of inventory at the start of the period
• Purchases is the cost of inventory acquired during the period
• Ending inventory is the value of inventory remaining at the end of the period

You’ll see the COGS calculation does not reference the number of sales – it focuses on the value of inventory at the beginning and end of the sales period instead. Doing it this way helps account for discarded inventory.

Manufacturing COGS formula

Manufacturers have more complex supply chains. It makes sense for them to add up all the costs on their product’s journey to the customer. Be aware that some choose not to count warehousing or freight.

Where:

• Raw materials: the direct materials used to produce goods
• Manufacturing costs: costs of production
• Storage costs: expenses from inventory storage
• Freight: any shipping costs for incoming materials or final delivery

If you use accounting software like Xero, you can find COGS in the P&L/income parts of your financial statements.

Examples of COGS

A retail business holds £10,000 of inventory at the beginning of the quarter, and it buys £25,000 during the quarter. At the end, it owns £8,000.

The equation is:

£10,000 + £25,000 − £8,000 = £27,000

A manufacturing business buys £7,000 worth of materials and spends £3,000 of energy and labour, turning it into goods, plus £1,200 on shipping.

The equation is:

£7,000 + £3,000 + £1,200 = £11,200

• Manufacturers tend to include certain indirect costs, such as material handling costs
• Retailers often calculate COGS using starting and ending inventory for a period
• Service businesses are more likely to include labour

Why COGS is important for small businesses

A business needs to know the true cost of serving its customers to settle on a competitive and profitable markup.

While materials and labour costs are typically easy to figure out, other costs can trip up those just starting out. For example, small business owners who start by using their home as a production facility or warehouse may enjoy good margins, but their COGS will jump when they upgrade to dedicated manufacturing or warehousing premises.

Monitoring COGS helps business owners identify and address the things that put pressure on their profit margins.

COGS also helps you make better business decisions in four key areas.

Pricing

COGS is fundamental in setting product prices and establishing the baseline costs that you must exceed to make a profit. Understanding COGS helps you more easily judge how cost fluctuations affect expenses and when to adjust prices.

Profitability

COGS is directly related to gross profit margin. Reducing COGS while maintaining prices increases gross profit. Even small improvements can significantly affect business profitability.

Keep in mind that COGS is just part of your operating expenses – your operating income also includes expenses like wages and depreciation.

Inventory management

Analysis of COGS helps you assess your inventory efficiency and identify slow-moving items. This insight helps you optimise your stock levels, reorder points, and product mix to balance demand while minimising the capital tied up in goods.

Taxes

COGS is a deductible business expense. Tracking and documenting all the components of COGS makes it easier to maximise deductions and provide the necessary audit documents.

Understanding COGS is key to calculating your profit margins to build a secure business.

Strategic decision-making

With a close eye on COGS accounting, you can make better decisions. COGs gives you the context for strategic financial analysis to inform decisions like investing in new product lines, automation, or new distribution methods.

Tips for managing and reducing COGS

Negotiate with suppliers

Have regular discussions with your suppliers to secure better prices. Consider long-term contracts or bulk purchasing agreements to leverage volume discounts, and don't hesitate to look for other suppliers who offer more-competitive rates.

Streamline production processes

Analyse your production workflow to identify inefficiencies and reduce waste. Consider investing in automation to decrease labour costs and increase output consistency (but you’ll need to assess the effects on COGS and ROI).

Optimise inventory levels

Use data analytics to accurately forecast demand so you can keep inventory levels optimal. Regularly review your product mix and consider discontinuing slow-moving items.

Reduce freight costs

Explore alternative shipping methods that balance cost and delivery time. For example, by consolidating shipments you can access bulk shipping rates. Try negotiating with carriers for volume discounts or think about a third-party logistics provider to optimise your shipping strategy.

COGS accounting methods

The method you use to value inventory directly affects the COGS calculation. As you sell inventory, its value transfers from the balance sheet to the income statement as part of COGS. The inventory valuation methods you choose determine which costs are assigned to sold items and which remain in inventory.

FIFO (first in, first out) method

FIFO assumes that the oldest inventory items are sold first. This method often results in COGS that closely matches the physical flow of goods. When prices are increasing, FIFO typically leads to lower COGS and higher reported profits.

LIFO (last in, first out) method

LIFO assumes the most recently acquired inventory is sold first. This can lead to higher COGS and lower profits during periods of inflation. Note that LIFO is not permitted under International Financial Reporting Standards (IFRS) cost-accounting principles and is disallowed in many countries outside the United States.

Average cost method

This method uses the weighted average inventory costs of individual items to value both COGS and ending inventory. It smooths out price fluctuations and is a middle ground between FIFO and LIFO.

Specific identification method

This method tracks the actual cost of each inventory item. It's typically used for high-value items. While accurate, it can be impractical for businesses with large quantities of similar items.

What's the difference between COGS and operating expenses?

COGS is the direct costs of creating products while operating expenses are the indirect costs of running the business (rent, marketing, staff, etc.).

What is the difference between cost of goods sold and cost of sales?

These are often used interchangeably. However, COGS focuses on the direct costs of creating or purchasing products that are sold. Cost of Sales (COS) sometimes includes those costs plus additional business expenses linked to revenue generation, like transaction fees, sale commissions, or acquisition costs in some digital businesses.

How often should I calculate COGS?

Generally, businesses calculate COGS at the end of each accounting period (monthly, quarterly, or annually). Businesses with high inventory turnover may calculate it more often for a better view of profitability. Talk to your accountant for specific advice for your business.

Can I estimate my COGS?

Yes, you can use estimates, especially if you're a new business or have limited resources. As your business grows, you’ll want to track COGs accurately as it directly affects your profitability and taxes. Accounting software can help.

My business is service-based. Do I still have COGS?

Yes, even service businesses have COGS. While you’re not selling physical goods, COGS can include the labour costs, software subscriptions, or materials you use to deliver the service.

Are salaries included in COGS?

Yes, even service businesses have COGS. While you’re not selling physical goods, COGS can include the labour costs, software subscriptions, or materials you use to deliver the service.

Conclusion

Understanding and managing your COGS is crucial for your business’s success. COGS directly affects your pricing strategies, profitability, inventory management, tax calculations, and overall decision-making processes.

Calculating and managing COGS can be complex. Accounting software like Xero gives you real-time reporting, detailed analytics, efficient expense management, and comprehensive inventory management, simplifying your CGS management and giving you more insight into your costs.

By tracking and optimising COGS, you can boost your profit margins and make data-informed business decisions that improve your long-term financial health.

Need a bookkeeper or accountant near you? Check out Xero Advisors.

Disclaimer

Xero does not provide accounting, tax, business or legal advice. This guide has been provided for information purposes only. You should consult your own professional advisors for advice directly relating to your business or before taking action in relation to any of the content provided.