Companies that sell products (and not services) have a financial reporting requirement called Cost of Goods Sold (COGS). Also referred to as “Cost of Sales”, COGS is an important term used in corporate accounting. It is a measure of the total direct costs incurred in producing goods that are purchased by customers. The sole purpose of calculating COGS is to compute the true cost of producing the merchandise that consumers purchased over the year. There are quite a few prerequisites to know what COGS is and how is it calculated:
1. What Does COGS Include?
COGS includes only those costs which are directly related to the manufacturing of the product. This can encompass the cost of raw materials used, labour to produce the product, items bought for resale and production overhead charges. For example, the COGS for an automobile manufacturer would include the material costs incurred in developing the car parts and the labour costs needed to assemble the car. It would not include the shipment charges, general administrative expenses or the labour put in to manufacture and sell the car. Further, COGS will not consider the costs for those cars which have not been purchased by anyone throughout the year.
2. How is COGS Calculated?
Cost of Goods Sold depends on the change in inventory, which is computed by the LIFO, FIFO or weighted average methods. The COGS is then determined by a simple formula:
COGS = (Beginning inventory) + (Purchases during the period) – (Ending inventory)
Beginning inventory is the inventory at the end of the previous year and purchases during the year refers to any new stock that was acquired during the year. This gives us the total cost of all the inventory. But we want to calculate the cost of inventory sold during the period. Thus, we subtract the ending, or unsold, inventory from the total. Ending inventory is the inventory that remains, or is not sold by the end of the year.
3. Why is COGS Calculated?
Cost of Goods Sold is an important factor on which the gross profit of an enterprise depends. It is subtracted from the company’s revenues to obtain the net profit. Cost of Goods Sold is used as a parameter in calculating whether your company is charging a sufficient amount to its customers for its goods. The Gross Profit on the sale of a company’s goods must be sufficient to not only cover the cost of the goods, but also to cover the general and administrative operating costs of your company.
When it comes to recording your company’s expenses, it is important for you to not only have a handle on it operationally, but also to ensure that the financial statements prepared will address all the needs of your business. However, you need not be an expert in this. You can focus on your business and leave the stress of corporate accounting to chartered professional accountants. They are here to help you maintain timely and credible financial records.