Cost of Goods Sold

The term cost of goods sold or COGS for short, is used by a business which holds inventory such as a manufacturer, retailer or wholesaler to refer to the total of the direct costs associated with producing, manufacturing, or obtaining the products which have been sold during the year.

If there are no sales, then there will be no cost of goods sold.

It is important to understand that until the products are sold, the costs of manufacturing or purchasing them form part of the inventory of the business. When the products are eventually sold, the same costs are transferred from inventory to the cost of goods sold.

It is for this reason that the costs of goods sold only ever includes costs which formed part of the inventory prior to being sold.

So for example, freight in costs for transporting the goods from the supplier to the business are incurred prior to sale and are included in the inventory/cost of goods sold costs, but carriage costs from the business to a customer are incurred after the sale has been made, and are not included in inventory/cost of goods sold.

For a business which does not hold inventory of a physical product such as a service based business the term cost of sales or cost of revenue is often used. As there is no inventory to worry about, cost of revenue can and often does include costs which are incurred after the sale has been made such as carriage costs to the customer or credit card charges.

Whats Included in Cost of Goods Sold

The costs to be included in cost of goods sold will vary depending on the type of business being operated. For example cost of goods sold for a manufacturing business will be different from that of a retailer or a wholesaler.

The following lists are not exhaustive, but give an indication of the type of costs which should be included in cost of goods sold.

Cost of Goods Sold in a Manufacturing Based Business

The main costs to be included are the costs of manufacturing the finished product including the following:

  • Direct labor
  • Direct materials
  • Purchase returns, discounts and allowances
  • Equipment hire
  • Other production costs
  • Allocated manufacturing overhead
  • Freight inwards
  • Depreciation

Cost of Goods Sold in a Retail/Wholesale Based Business

A retailer or wholesaler usually purchases products from a supplier. The cost of good sold includes the cost of purchasing the product and getting it into a position ready for sale.

  • Purchase cost of the product
  • Purchase returns, discounts and allowances
  • Freight inwards
  • Costs of adapting the product for sale

Calculating Cost of Good Sold

In an inventory based business, the value of the cost of goods sold can be calculated using the cost of good sold formula as follows:

Cost of goods sold = Beginning inventory + Purchases – Ending inventory

In this formula purchases includes the cost of freight in, and deductions for purchase returns, allowances, and purchase discounts.

For example is a business had beginning inventory of 20,000, ending inventory of 25,000, and had spent 115,000 on purchases such as materials, labor etc, then the cost of good sold is calculated as follows:

Cost of good sold = Beginning inventory + Purchases - Ending inventory
Cost of good sold = 20,000 + 115,000 - 25,000 = 110,000

Calculating the Gross Margin % Using the Cost of Goods Sold

The cost of goods sold is an important number for any business as it is used to determine the gross margin and the gross margin percentage.

Irrespective of whats included in cost of goods sold, the calculation of the gross margin percentage for use in the financial projections template is always the same.

Cost of good sold and gross margin
Account
Selling price 150
Cost of good sold 60
Gross margin 90

In this example, the gross margin is 90/150 = 60%. For a given selling price, the higher the cost of good sold the lower the gross margin percentage of the product.

Our gross margin calculator can be used to estimate the cost of good sold and gross margin percentage for a product or alternatively our industry specific calculators are available for a range of business types.

Cost of Sales vs Cost of Goods Sold

To allow for flexibility, in the financial projections template the term cost of sales is used on the income statement. For an inventory based business it is preferable that this should be the same as the cost of goods sold described above. For a non-inventory based business, the cost of sales line can be adapted to suit the business to include appropriate costs which are not necessarily incurred prior to the sale, such as credit card charges and customer distribution costs.

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