Cost of goods sold (COGS) refer to the direct costs of producing end-products or to purchase them from manufacturers, to sell to the company’s customers.
While COGS can have an important role in play in the planning of business strategy, it is a term that is mostly used in accounting income statements.
This is because a company has various expenses to keep an eye on other than costs of goods sold.
COGS can have different ways of calculation to different types of businesses.
This is most obvious between a trading business and a manufacturing business.
For a trading business which probably just purchases inventory via imports and sell them to end-users or export them to wholesalers, the costs of acquiring these products are the price of the goods.
Therefore the COGS is basically the amount of money spent on inventory.
As gross profit is sales minus COGS, this essentially means that a low COGS would result in a higher gross profit.
Other expenses would then have to be factored in to derive a net profit.
While a trading business purchases end-products as inventory to be resold, a manufacturer creates their own end-products by working with raw materials.
So the COGS of a manufacturing business has to account for raw materials and partially worked materials (work-in-progress).
This distinctively differs from a trading business.
Raw materials are purchased from suppliers while work-in-progress are raw materials that in the process of being converted into real products.
It is totally possible for a manufacturer to manufacture their product, then sell them to trading businesses.
This in effect means that the inputs of COGS can be applied twice (or more) before a consumer ends up buying the product and bringing it home for use.
For accounting purposes, the cost of goods sold is not simply the amount of funds that has been used to purchase inventory.
This is because it is totally possible, and very likely, that a trading company would already be holding stocks carried over from the previous account year, and sold in the latest year.
So this might not correctly reflect the actual COGS of the business.
As such, COGS is calculated by taking the opening inventory balance, plus the inventory purchase, less the closing balance.
This can be expressed by:
For example, an opening balance of $100 plus purchases of $200 less a closing balance of $50 would be $100 + $200 – $50 = $250. COGS would be $250.
Using the revenue less COGS, we would derive the gross profit.
After which, other expenses can be deducted to calculate the net profit.
It should also be noted that the closing balance of $50 would make it’s way into the balance sheet as an entry in the section that list current assets.
Business people should also remember that accounting standards can vary from place to place. In addition, they can also change from time to time.
So unless you are a professional accountant, it’s better to leave the job of accounting to real qualified accountants to avoid running into trouble with the law.