Businesses are often faced with a tough choice: buy cheaper materials to keep prices low, or focus on high-quality goods that can bring in higher profits? Both strategies can increase demand and ultimately support profitability, but the right solution may not be one or the other. Instead, striking a balance between cost-cutting and offering value can often be the best strategy. But to find the balance that works best for their customers, businesses should have a comprehensive understanding of their costs and profit margins, and calculating the cost of goods sold is a great place to start.
This article will explain what cost of goods sold (COGS) is, its formula, how businesses can use COGS to keep a close eye on costs, and why it’s an especially crucial metric to SMEs.
What Is Cost of Goods Sold (COGS)?
The cost of goods sold, or COGS, is the total direct costs accrued while creating a product or providing a service. This includes expenses such as raw materials, labor, and manufacturing costs. Because COGS excludes indirect costs such as marketing and distribution, it’s a useful measure to track the direct profitability of the business’s core purpose: making and selling goods to customers. COGS can therefore reveal areas where costs can be reduced or value can be added without negatively affecting the bottom line.
For example, if a bakery buys flour, sugar, and eggs to make a cake, and pays an employee to bake it, these costs – the ingredients and the labor – would be included in COGS. But the cost of advertising the cake or delivering it to a customer would not be.
Why Calculate the Cost of Goods Sold?
Business leaders can use COGS to calculate overall profitability of goods, to better understand what costs are associated with selling a product or service, and to support strategic business decisions on pricing, material procurement, and more.
For instance, both consumers and businesses are sensitive to price changes. By understanding COGS, companies can identify potential savings and avoid passing all cost increases onto their customers. When calculating COGS, decision makers may find unexpected opportunities to increase revenue, such as reducing pack sizes, fixing input prices, or even improving manufacturing efficiency – all alternatives to increasing prices and potentially driving away sales.
By improving their COGS ratio, businesses can help boost their earnings, fueling growth and ensuring a more resilient future.
While COGS often relies on external cost pressures, such as vendor rates and minimum wage requirements, businesses can also use an internal COGS analysis to plan targeted cuts. Say a clothing manufacturer identifies rising material costs without a proportional increase in output. Business leaders can study COGS to analyze production processes and identify the cost drivers and plan improvements. An inefficient production process may cause an increase in wasted fabrics and investing in more sophisticated equipment can reduce waste, and with it, costs. This could also potentially create a higher quality product. On the other hand, if costs are rising due to increased vendor prices, renegotiating terms or streamlining procurement can lead to cost-saving benefits, like bulk discounts or exclusivity pricing perks.
What Do You Need to Work Out Cost of Goods Sold?
To accurately calculate the cost of goods sold, businesses need reliable data for the financial period being measured. Most businesses pull this data from their accounting system to ensure that their records are accurate and up to date.
Every product is different and may have unique expenses, but most COGS calculations are based around two categories:
- Inventory: What is the total cost of inventory during the financial period? How did the value of inventory change?
- Expenses: How much has the company spent while producing its goods or providing its services during the financial period?
To get a more detailed view of expenses, many financial professionals will break them down into three subcategories:
- Labor: How much has the company spent on direct wages while producing its products or providing its services?
- Materials: What has the company spent on materials and supplies to make the products that have been sold during the financial period?
- Other expenses: What expenses in the business are related to products/services? This should include incoming material shipping costs. For manufacturing and production facilities only, specific overheads like rent and utilities can also be factored into COGS.
Remember, these expenses do not include indirect labor, such as sales teams and administrative salaries, or overheads for corporate offices, for instance.
How to Calculate Cost of Goods Sold
To calculate COGS, businesses should consider all the direct costs associated with a product or service. It’s important to remember that COGS is the sum of direct expenses incurred by products and services, but only includes those that the business has sold. This distinction is important to show how costs compare to revenue generated over the measured period.
Businesses typically begin COGS calculations with the opening inventory, which is the total value of items in stock and ready to be used or sold at the start of an accounting period. They then add net direct costs. Finally, they deduct the closing inventory, which represents the total value of leftover stock at the end of the period.
Cost of Goods Sold (COGS) Formula
Rather than manually counting every sold good and allocating costs accordingly, businesses can use this simple formula to calculate COGS:
Opening Inventory + Net Costs – Closing Inventory = Cost of Goods Sold
Some businesses, especially those with consistent demand, expenses, and production schedules, may be comfortable only tracking COGS quarterly or monthly, while companies with more volatile finances may track COGS more frequently.
Cost of Goods Sold Calculation Example
Say a clothing manufacturer opens the financial period with $100,000 in opening inventory. Then, during the period, the company incurs $60,000 in costs for materials and labor and ends the period with $30,000 in unsold inventory. Cost of goods sold would be calculated like this:
$100,000 (Opening Inventory) + $60,000 (Net Costs) – $30,000 (Closing Inventory) = $130,000 (Cost of Goods Sold)
Calculating Cost of Goods Sold (COGS) Ratio
Taking this process one step further, the cost of goods sold can be expressed as a ratio to understand how much of the revenue generated by the business is being used to pay for expenses that are directly related to supplying products and services.
To calculate the COGS ratio, use this formula:
(COGS / Net Sales) x 100 = Cost of Goods Ratio
If a company has a COGS of $1 million, with net sales of $1.5 million, for example, then the calculation would be:
($1,000,000 / $1,500,000) x 100 = 67%
This means the company spent 67% of its revenue on creating products or delivering services in this period.
A low COGS ratio shows that the direct costs related to selling products are low in comparison to incoming revenue from sales, and therefore the potential profit is higher. Because this “extra” revenue should fund the rest of the business’s operations, including administrative salaries, marketing costs, and long-term investments, a low COGS ratio can point to a healthy and sustainable business.
A higher COGS ratio, on the other hand, means that the costs incurred in production are higher in comparison to the generated sales. Businesses that expect a high COGS ratio can compensate by increasing sales volumes or finding areas to cut costs during their production process. Even small improvements to the COGS ratio can lead to big increases in profit margins.
For example, if a furniture store generates $200,000 in revenue but the COGS for that revenue is $160,000 (an 80% ratio) then gross profits will only be $40,000. Despite the positive revenues, the business may find it challenging to find the cash to invest in growth or meet sudden peaks in demand. If the business is able to reduce the COGS ratio to 70% by streamlining the manufacturing process and finding a cheaper supplier, it would earn an additional $20,000 of profit without increasing revenue, a 50% increase from its original gross profit margin. This additional cash can help make it easier for the business to thrive and build long-term success.
The Bottom Line
The cost of goods sold is an essential metric for tracking the profitability of a business’s core operations: producing and selling goods and/or services to customers. COGS encapsulates all direct costs associated with creating a product or delivering a service. By then expressing this as a ratio – COGS divided by net sales – analysts can determine the proportion of revenue is spent on these direct costs. The remaining percentage indicates the gross profit, which can be used to fund other business operations and investments. By improving their COGS ratio, businesses can help boost their earnings, fueling growth and ensuring a more resilient future.
Photo: Getty Images