COGS: What is cost of Goods Sold?
COGS is costs associated with production of goods this is primarily applicable only to manufacturing businesses. To manufacture any goods there are costs included like Raw Material, Labour, Power etc... which are considered as direct costs to make finished goods. However, Cost of Goods Sold doesn’t apply to services business where the nature of business is to generate revenue from services offered and not based on goods produced and sold but based on its employees and service they offer hence CAGS is not a valid instrument in services business.
What items should be included in costs of goods sold?
COGS mainly include three components:
Direct Labour Cost and
For example: A Mobile manufacturing company need to use Steel, Plastic, Aluminium and Rubber components to build a Car. Along with direct labour force used in the manufacturing facility. Overhead cost in such case are Power cost and plant equipment’s whose cost is calculated in terms of yearly depreciation.
How do you Calculate cost of Goods Sold?
Formula for COGS: Beginning Inventory + Purchases During the year - Ending Inventory = Cost of Goods Sold.
This essentially means Cost of Inventory used during the year to produce goods which are sold during the financial year. Beginning inventory is taken from last year’s financials which is shown as closing inventory for that particular year. Purchases during the year and closing inventory can be found in current year financials. Inventory is found on Balance Sheet under Current assets.
Cost of Goods Sold Example:
Take an example of company having $50,000 of inventory at the beginning of the year, purchases various raw material during the year to the tune of $35,000, and reported a closing inventory at the end of the year at $20,000.
What is the COGS here?
COGS = $50,000 Beginning inventory + $35,000 Purchases during the year - $20,000 Ending inventory = $65,000 is Cost of goods sold.
Factors Impacting COGS:
Cost of Goods Sold varies depending upon the costing methodology used in calculating based on inventory used. There are three major methods used:
FIFO: First come first out
LIFO: Last come last out
Let us understand how this impact COGS Calculations
Why Would Cost of goods sold decrease?
This is because if the company uses LIFO methodology, as per which inventory used is the last come first out method. Given inflationary environment where price of raw materials is rising which adds to the year’s production cost or COGS for the particular year which tend to be lower under this method. And may result in higher Gross Profit under balance sheet. On the contrary in a deflationary scenario the COGS increase as older inventory carries higher cost and used in manufacturing. In such case Companies balance sheet shows lower Gross Profit.
What would cause an increase in cost of goods sold?
Under FIFO method company use inventory which comes first. Scenario where raw material prices are rising (Inflationary effect) result in higher inventory cost and ultimately higher COGS. Which reflects it lower Gross profit. On the other hand, where in raw material prices are coming down (deflationary effect) and FIFO is followed COGS will come down and result in Higher Gross Profit Margins.
COGS under Average Cost Method?
This is a neutral and doesn’t affect the inflation or deflation of raw material in significant way. And keeps gross profit margins stable and less impacted by methods in use like FIFO and LIFO. Under this method the average cost of materials consumed during the year is taken for COGS calculation.
COGS is important major to calculate companies’ ability to control its manufacturing cost and maintain stable gross margins. However other than raw material cost labour cost and overhead costs shown from year on year needs to be carefully examined. In situation where company uses FIFO and prices of raw materials are coming down still the other cost associated like labour and overheads make up for the gap, then there is no positive effect of lower raw material prices on the balance sheet. Whether this is market related or adjusted to show stable gross margins needs to be examined.