Also abbreviated as COGS, the cost of goods sold measures the direct costs that were sustained during the production of products that were sold during a certain period. In short, this managerial calculation determines how much the company spent on materials, labor, and overhead to purchase or manufacture those products that were sold during the year.
Important to remember is the fact that cost of goods sold does not include the expenses sustained to make the products that have not yet been sold – only the cost of the products that have been successfully sold is taken into account.
The reason why the latter costs are not taken into consideration is that the company that calculates this wants to find out what is called the true cost of merchandise production – specifically only the items that have been bought count towards this true cost.
The Basics of Cost of Goods Sold
The cost of goods sold helps the management teams analyze the control of the payroll costs and purchasing of certain products. Moreover, this variable is not used only by management – investors and credits also make use of it in order to calculate the gross margin of a certain business and determine the exact percentage of revenues that are available to cover the operation of expenses.
The gross margin is calculated by subtracting the cost of goods sold from the total revenue. The cost of goods sold is listed on the income statement as expenses and after the total revenues for a certain period.
The Formula of Cost of Goods Sold
Calculating the COGS is quite simple and intuitive – you take the beginning inventory and add any purchases to it, after which you subtract the ending inventory for the period of time you want to find the cost of goods sold for.
As we said, the formula is pretty much straightforward. For example, when the year starts, you have a certain batch of products that are ready to be sold. After a while, you’ll buy a new batch, to refresh your stock – naturally, these are added to the beginning inventory, as you wish to find the cost of all of the goods sold in a year.
Then, obviously, you remove the prices of the ending inventory from the previous result, and you are left with the information you need to know – the COGS.
One interesting thing is that this formula doesn’t mention the order in which the inventory should be sold. Because of this, we have multiple ways to calculate the cost of goods sold, namely, first-in, first-out (FIFO), and last-in, last-out (LIFO). Moreover, you could also calculate this variable using a periodic or a perpetual inventory system.
Once again, these means of calculation are quite intuitive and you’ll get used to them in no time – but your preferences are to be taken into account as well. Each of the ways mentioned above comes with advantages and disadvantages and that’s why you have to conduct a proper research and find out which one of them fits your business the best.