Cost of goods sold: Everything you need to know
When business owners want to increase their bottom line, they usually try to increase their sales. But does this way always work best?
Consider this question: Will you increase your bottom line faster by selling 10% more or by reducing your cost of goods sold (including labor, materials, and subcontractor services) by 5%? The answer is the first one. In fact, it is not easy to boost your sales, because it involves both external and internal factors. Meanwhile, if you want, you can directly take cost reduction under your control.
If you still find it complicated and hard-to-understand, read this guide until the last words to learn more about what is the cost of goods sold, how to calculate, and how to reduce your Cost of Goods Sold.
Table Of Contents
- What is Cost of Goods Sold?
- How to calculate Cost of Goods Sold?
- Why does Cost of Goods Sold matter a lot?
- How to reduce Cost of Goods Sold?
- The bottom line
What is Cost of Goods Sold?
Cost of Goods Sold (COGS) refers to the direct costs required to produce the goods sold by a company over a particular period. Some examples of direct costs are listed below:
- Direct labor
- Direct materials
- Manufacturing supplies
- Wages for the production staff
- Fuel or power consumption
Cost of Goods Sold excludes indirect expenses, such as administrative salaries, rent, security expenses, or distribution costs.
Also known as simply “cost of goods” or “costs of sales,” COGS is a critical number on the profit and loss statement of inventory-based companies. Without this number, you can not measure your gross profit, which is a crucial metric to know when you’re trying to maximize the profitability of your business.
How to calculate Cost of Goods Sold?
To calculate Cost of Goods Sold, you simply follow this formula:
COGS = Beginning inventory + Additional purchases - Ending inventory
Beginning inventory: the total cost of every product in your inventory at the start of the year. This number should be exactly the same as your ending inventory at the end of the year before.
Additional purchases: total additional COGS purchased throughout the year.
Ending inventory: the total cost of every product in your inventory at the end of the year.
- Inventory recorded at the start of the fiscal year ended 2019 is $2,000
- Additional inventory purchased during the fiscal year 2019-2020 is $1,500
- Inventory recorded at the end of the fiscal year ended 2020 is $1,000
Therefore, Cost of Goods Sold = 2,000 + 1,500 - 1,000 = $2,500
However, we would be remiss if we didn’t take a little bit of time to look at the most common inventory valuation methods. Why? Because the method you choose can have a significant impact on your COGS calculation.
Following are three inventory valuation methods that are most commonly used:
- FIFO (First-in, first-out)
This method assumes that the first inventory purchased will be the first used. FIFO inventory valuation is often used when products have an expiry date, such as milk at the grocery store.
For instance, if your business sold 100 units of an item and 80 units were originally purchased at $15.00, and 20 remaining units were purchased at $20.00, it cannot assign the $15.00 cost price to every unit sold. Only 80 units can be. The remaining 20 items must be assigned to a higher price, $20.00. FIFO method is closer to the actual physical flow of goods because companies usually sell goods in order in which they are purchased or produced.
- LIFO (Last-in, first-out)
This method is exactly opposite to the FIFO method, which assumes that the most recent products added to a company’s inventory will be sold first.
Assume your company purchases 10 makeup sets. The first 5 sets cost $50 each and arrived two days ago. The last 5 sets cost $100 each and arrived one day ago. Based on the LIFO method, the last makeup sets are the first ones to be sold. Then, if 7 sets are sold, the cost of makeup sets equals $100 x 5 + $50 x 2 = $600.
However, LIFO inventory valuation is no longer used in most countries (in fact, it has been banned everywhere except the US) because it can dramatically distort inventory (and COGS) figures.
- WAC (Weighted average cost)
The weighted average cost method is the easiest inventory valuation method to apply. It is commonly used when a business sells many of the same items and tracking each item individually doesn’t make sense.
For the example in LIFO section,
Cost of a makeup set = [(5 x $50) + (5 x $100)] / 10 = $75 COGS: $75 x 7 = $525
Cost of goods sold is an essential calculation for any inventory-driven business. However, before calculating COGS, check with your accountant to choose the best inventory management method for your business. Doing this first will help you measure your COGS correctly, which will, in turn, result in accurate financial figures to help you make sound business decisions. You can find more information on the inventory valuation at IRS Publication 538.
Why does Cost of Goods Sold matter a lot?
Cost of Goods Sold is a component of the Income Statement and plays a significant part in calculating your Net Income. Determining COGS is an important step in understanding the profitability of a business, and it can have a considerable effect on your taxable income.
Here are a few good reasons why you need to keep an eye on COGS:
COGS shows the operational costs of the production of goods and services. If the cost of sales is increasing while revenue has stagnated, it might be an indication that input costs have risen or other direct costs are not being effectively managed.
COGS determines gross profit, as it is subtracted from a company’s revenues. It can not be denied that profit is important in the process of growing your business and assessing your company’s overall financial health - and COGS is a piece of that profit picture.
If you know your COGS, you can set product prices that leave you a healthy profit margin. COGS can also help you to determine when prices on a particular product need to go up or down.
The calculation of COGS has a direct impact on your tax situation. COGS is considered an expense; therefore, the larger it is, the lower your taxable income. Besides, if your business carries inventory, the value of your inventory at the end of the year is calculated using COGS, and your inventory may be taxable. So, make sure to discuss it with a tax professional.
By keeping track of your COGS, you can identify areas of opportunities for improvement and growth, or stop producing altogether.
How to reduce Cost of Goods Sold?
Whatever product your company makes, the direct costs are probably one of the most headache issues that need your consideration, as they can directly affect your profitability. But how do you reduce direct costs without impacting the quality of your final product and altering what your customers have come to expect and rely on?
Like most effective cost-benefit analysis, reducing the COGS starts with a thorough analysis of the various ways to make it work efficiently.
Take advantage of lower-cost materials where possible
It is likely that in a retail business, the largest component of expense you have to incur is your material costs. Therefore when considering a change in materials used in your product manufacturing, be sure to recognize all factors involved, such as prices, supply & demand, technology adoption, and even political goals. Where possible, you might opt to change materials in order to reduce the cost of the manufacturing process and thus your COGS.
An important thing that needs consideration is that you might also test whether a component of your product plays an important role in your customers’ minds or not. For example, your product targets environment-friendly features, and you use recyclable materials, which costs more than normal plastic. However, if your customers do not highly value this, it would be better to switch to less expensive input materials.
Remember to swap in lower-cost materials, but not to erode the quality of your product through an obsessive pursuit of a lower price. Otherwise, you can drive your customers far away.
Buy in large quantity and receive discounts
When you place a bulk order, you will be able to take advantage of attractive discounts. Besides, you may also benefit from shipping discounts, as it is cheaper to per unit to ship a container full of products rather than a pallet. So, ask your suppliers what kind of discounts you are offered to indirectly reduce your COGS more effectively.
In case your products are not too unique, there are various alternative suppliers of similar products available to you. Determine whether there are any different features among suppliers and which features really benefit you and your customers. Is it worthwhile, for example, to have a faster delivery time, or favorable discount rate? If it is difficult to choose, purchase from the supplier offering products at the lowest cost.
Negotiate with your suppliers
Building strong relationships with your suppliers and vendors is the key to the success of your business, but that doesn’t mean you can try to get the best deal. In order to reduce your COGS, develop an approach to negotiate with your suppliers.
Of course, you know your suppliers desire to be profitable just like you are, but you also want to avoid leaving too much money on the table.
The level of your profit dramatically depends upon your ability to receive the highest possible price for your products, and pay the lowest reasonable price to your vendors and suppliers.
You can apply these following negotiation platforms:
- Asking for bulk discounts
- Asking for discounts when paying invoices more quickly
- Asking for buying bargains
- Joining formal or informal trade cooperatives, where multiple retailers can negotiate for better prices.
Wastage can be a significant component of COGS, and it comes in many forms. When manufacturing a product, there may be non-standard features that require an additional step in the production process, increasing the expense.
Therefore, examine your customers’ motives for purchasing your products, asking them the reason why they choose your products, because of low cost, high quality, unique look, or other purposes. By determining what your customers really need, you can selectively detect unnecessary elements to reduce costs.
Invest in automating processes
Automating processes refer to the ability of a system to execute a series of tasks that are initially performed by humans. Companies implementing process automation have a competitive advantage over their competitors, both in operability and reliability.
Process automation reduces operative costs and increases both the speed and reliability of task implementation, development, and support. Besides, it can eliminate the manual execution of command sequences subjected to human error, increasing efficiency, and productivity of the organization.
Offshore your operations or manufacturing
Offshoring refers to the relocation of a business process to another country, where material and labor costs are cheaper. This model of business is not new, as many globalized companies around the world have used it for many years.
In recent years, China has become a favorite offshoring destination for Western business owners for its substantially lower labor and material costs. However, be sure to understand both sides of offshoring, which can be episodic and detrimental to your business. There can be language and communication barriers, cultural and social issues, or quality control problems.
The bottom line
The cost of goods sold is considered the pulse of a company; therefore, every business needs to track and understand it thoroughly. When appropriately used, COGS is a useful calculation for both management and external users to evaluate how well the company is purchasing and selling its inventory.
This guide has provided the necessary information on everything related to COGS, especially useful tips to reduce COGS, in the hope of helping you calculate your taxable income, shed insight on a business’s profitability, and make strategic business decisions.