Calculating the Cost of Goods Sold

For manufacturers, cost of goods sold (COGS) is the cost of buying raw materials and manufacturing finished products. For retailers, its the cost of obtaining or buying the products sold to customers. If the company is in a service industry, COGS is the cost of the service it offers. COGS can help companies work out how much they should charge for their products and services, and the level of sales they need to sustain in order to make a profit. The price paid for products is particularly crucial to retailers, as it is often their greatest area of expenditure. But all businesses can benefit from an analysis of COGS, as it can highlight ways of improving efficiency and cutting expenditure. COGS is closely related to inventorywhich is treated as potential revenue in relation to taxso its also essential information for a companys profit and loss account (income tax return).

What to Do
COGS describes the direct costs involved in producing products or services. At its simplest, the calculation takes the value of inventory at the beginning of a specified period, plus the value of purchases, and subtracts the value of inventory at the end of the period. Expressed as a formula, it looks like this: Beginning Inventory + Purchases End Inventory = COGS

Example 1:
Suppose the opening inventory is Rs.30,000 and purchases during the period are Rs.50,000. At the end of the period, inventory is Rs.15,000so: COGS = 30,000 + (50,000 15,000) = Rs.65,000 The value of inventory may be calculated using a First In First Out (FIFO) policywhich takes its original costor a Last In First Out (LIFO) policy, which takes its present (usually higher) cost. Its important to know which method is being used, especially if inflation rates are running high, as it could make a significant difference to the result. In manufacturing companies, direct costs may include such things as: labor costs and workforce benefits; raw materials and raw materials inventory; energy costs related to production; shipping and warehousing; factory overheads; and depreciation of equipment and machinery.

Example 2:
Suppose the opening inventory is Rs.25,000 and purchases during the period are Rs.45,000. The cost of direct labor is Rs.15,000, and raw materials plus energy costs are Rs.10,000. Total product expenses are therefore 25,000 + 45,000 + 15,000 + 10,000 = Rs.95,000. At the end of the period, inventory is Rs.10,000, so: COGS = 25,000 + 45,000 + (95,000 10,000) = Rs.155,000 Its usually less complicated in the retail sector, where COGS is simply the amount spent on buying or acquiring products that are sold on to the customer. The tax rules allow retailers to estimate COGS because taking inventory is such a laborintensive activity and can be prone to error. Most retailers take last years net sales and gross profit margin (which they use work out a cost ratio) in order to estimate COGS.

Example 3:
Suppose net sales are 100%, and the gross profit margin is 35%. The cost ratio is 100 35 = 65%. So COGS is calculated as follows: Opening inventory = Rs.15,000 Purchases = Rs.30,000 Net sales = Rs.35,000 Cost ratio = 65% Estimated COGS = 45,000 (35,000 0.65) = 45,000 22,750 = Rs.22,250

What You Need to Know

Its essential that a company stays on top of its inventory and recognizes its value, if COGS is to be meaningful. Goods returned must be taken into account when calculating COGS, because they affect the value of inventory. Different methods of accounting for inventory will give the same answer but costs may be allocated differently. Because indirect costs like administration or promotions are not involved in production, they should not be included in COGS calculations.