Cost of Goods Sold (COGS) in a Startup

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 sell, 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 form part of the inventory prior to sale.

So for example, freight in costs for transporting the goods from the supplier to the business are incurred prior to sale. Consequently they are included in the inventory or cost of goods sold. In contrast, carriage costs from the business to a customer are incurred after the sale has been made. Such costs are therefore not included in inventory or cost of goods sold.

In contrast 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 costs include carriage costs to the customer and 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 manufacturer 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.

Costs 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. Accordingly 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 COGS

As an illustration in a manufacturing based business, the value of the cost of goods sold can be calculated using the cost of good sold formula as follows:

It is important to realize that in this formula manufacturing costs includes direct labor and materials, purchase returns, discounts and allowances, freight inwards, manufacturing overhead, and other production costs.

For example suppose a business had beginning inventory of 40,000, ending inventory of 32,000, and had manufacturing costs of 156,000. The calculation of the cost of good sold is as follows:

Cost of good sold = Beginning inventory + Manufacturing costs - Ending inventory
Cost of good sold = 40,000 + 156,000 - 32,000 = 164,000

In like fashion in a retail or wholesale based business, the value of the COGS can be calculated using a similar formula as follows:

It is important to realize that in this formula purchases includes the cost of freight in, and deductions for purchase returns, allowances, and purchase discounts.

For example suppose a business had beginning inventory of 20,000, ending inventory of 25,000, and had spent 115,000 on purchases. The calculation of the cost of good sold is 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 COGS

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 the costs included in COGS, the calculation of the gross margin percentage is always the same.

As can be seen in this example, the gross margin is 90/150 = 60%. Generally given a selling price, the higher the cost of good sold the lower the product gross margin percentage.

Additionally 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 COGS described above. For a non-inventory based business, the cost of sales or cost of revenue 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.