Running a business can feel like a rollercoaster ride at times, but understanding your company’s profitability can help even out the hills and valleys. Start by using the simple cost of goods sold (COGS) calculation to make better business decisions, reinvest in your company or even scale back when needed.
What Is Cost of Goods Sold (COGS)?
The cost of goods sold measures just how much a company spends on the goods and services that go into its own goods and services. And while the metric is most often used by product-oriented companies that buy physical goods and materials, certain service-based businesses can also use the measure.
At a high level, COGS includes all of the materials, labor expenses and other direct overhead that a company has to pay for in order to produce products for its customers. As organizations grow, their COGS logically increases to account for the greater number of goods or services being produced.
Why is COGS Important?
An accurate COGS helps businesses, investors and other stakeholders better understand a company’s financial standing, efficiency and profitability. For example, if COGS rises substantially during a specific period (e.g., month, quarter, etc.), it may be an indicator of lower operating margins and that the company is operating at a loss.
On the other hand, if COGS goes down during the specified period, then that could mean the organization is operating more efficiently, getting better pricing on its raw materials or finding ways to get more done with fewer labor resources.
Calculating COGS
Tracking COGS is about more than just knowing whether your company is profitable or not. It can also help you identify places where cutbacks are in order, inform price adjustments and help you generate more accurate financial statements.
Both product and service businesses can use this simple equation to calculate COGS:
Your starting inventory + purchases – ending inventory = your company’s COGS
Starting inventory represents the value of goods at the start of the accounting period. Purchases include all goods acquired during that period, and ending inventory is everything that’s left over at the end of the accounting period. The accounting period may be one month, one quarter or a full year, depending on your specific operation.
COGS Accounting Methods
Companies use different accounting methods for inventory valuations that, in turn, determine exactly how COGS is calculated. The most-used accounting methods include first-in, first-out (FIFO), last-in/first-out (LIFO) and average cost:
- FIFO: The oldest inventory currently in stock is used for the COGS calculation.
- LIFO: The newest inventory currently in stock is used to calculate COGS.
- Average cost: The cost of goods purchased is divided by the total number of items in stock, with the result being average cost per item.
Specific industries measure inventory based on a number of factors. For example, if you’re in a sector where inventory costs fluctuate regularly (e.g., one that’s aligned with the commodity markets) then FIFO or LIFO may be the preferred methods.
However, if your organization sells a high volume of similar items (e.g., an e- commerce company that sells housewares or apparel)—and if tracking the purchase dates on those goods is cumbersome—then average cost method may be the preferred inventory valuation approach.
What Goes into the COGS Metric?
The COGS metric is used by both product and service businesses. Because product companies carry and sell inventory, the formula is fairly straightforward. Regardless of its business model, a company would typically include any or all of these costs in the COGS calculation:
- Material cost
- Direct labor cost
- Direct factory overhead costs[1]
Not all service-based businesses keep track of cost of goods sold — it depends on how they use inventory. Here’s how it works for two different service businesses:
A public relations firm that uses office supplies, ships packets of materials to customers and pays sales commissions to reps during the normal course of business probably doesn’t need to use the COGS metric.
However, the landscaping specialist who buys plants, fertilizer, sod and mulch can use COGS to better understand the direct cost of providing its services. The metric can then be used to set competitive package prices that include both the products and the services.
Mistakes to Avoid When Calculating COGS
Only certain expenses are figured into COGS. For example, you don’t want to include any indirect business costs like cost of revenue (for service businesses), operating expenses (which go on the income statement), or cost of sales when calculating COGS.
These are important considerations because the COGS metric only factors in the expenses directly related to the production of goods, and it excludes indirect costs like overhead, sales and marketing. Indirect costs are incurred when creating a product, and include the expenses associated with maintaining and running a business.
Accuracy is also important with COGS, and not just for your own decision making, but also because outside investors or other stakeholders may use the measure to determine your company’s current financial health and prospects.
Here are two scenarios that you’ll want to avoid with respect to calculating and sharing COGS data:
- Inaccurate inventory reports. Because COGS is tightly tied to your inventory counts during the specified period, an inaccurate count will produce an inaccurate COGS.
- Under-reporting COGS. If this happens, then your organization’s net income and gross margins won’t be accurate. This is a problem because investors and other stakeholders use those metrics to analyze financial statements (which will also be incorrect).
COGS: A Window Into Your Company’s Financial Health
Whether you’re producing a good, providing a service or a little of both, be sure to include COGS with your company’s other financial metrics. By monitoring COGS on a regular schedule, you can better determine the efficiency, cost control and potential profitability of your company. You can also use COGS to determine the true cost of sales, hone your inventory management approach and set competitive pricing that aligns with your business strategy.
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