Understanding Cost of Goods Sold

COGS stands for Cost of Goods Sold. It only includes the costs of making your product without including any other business costs.

This article will help you learn the basics of COGS: how it can help control costs, set the correct prices, and increase profits.

This guide also relates to our articles on gross vs. net profit, cash vs. accrual accounting, and how to read a balance sheet.

This list includes:

• Cost of goods sold formula
• Calculating COGS
• COGS and gross profit
• COGS management strategies
• COGS in financial statements

Let’s dive in!

Definition and fundamental components of COGS

The cost of Goods Sold (COGS) is money spent to make or buy the products you sell. If you’re making cakes, COGS includes the flour, eggs, and sugar you buy. If you’re selling gadgets, it’s what you pay to get them from the manufacturer. 

The components of COGS are:

• Materials: Everything you need to make your product.
• Labor: Direct labor specifically for your product.

Distinction between COGS and other operating expenses

COGS differs from other business expenses, such as advertising or rent. Those are operating expenses (the cost of running your business). COGS is the direct cost of creating your products. 

The role of COGS in financial statements and performance metrics

Understanding your business’s financial health can be challenging, but COGS can help. COGS directly affects gross profit (Gross Profit = Sales – COGS). This is your business’s earnings from selling goods before subtracting all the other operating expenses. 

A lower COGS means a higher gross profit, which is great news for your business. Monitoring COGS helps you price products correctly and see where costs can be cut to boost profits. 

To effectively manage your COGS, follow these steps:

1. Track every penny: Closely monitor spending on materials, labor, and overhead. Small changes can add up and impact gross profit.
2. Separate costs: Be clear about the difference between COGS and operating expenses. This clarity is necessary for accurate financial reporting and making well-informed decisions.
3. Evaluate suppliers: Finding a new supplier or negotiating better terms can lower your COGS. Always look for opportunities to reduce costs without compromising on quality.

By keeping a keen eye on COGS, you’ll be better equipped to help your business thrive.

Calculating cost of goods sold

Here’s a simple formula to calculate COGS:

COGS = Opening Inventory + Purchases during the period – Closing Inventory

Let’s break down each part of this formula:

Opening inventory: Finished goods, materials, and supplies on hand. Include all raw materials and the items you buy to resell.

+Purchases during the period: All additional products, materials, and supplies you bought to create your goods. Remember, this includes raw materials and any items you purchase to sell directly.

-Closing inventory: is everything left at the end of the period that you didn’t sell or use in production.

Understanding and accurately applying each component ensures that your COGS reflects the actual cost of goods sold during the period. 

Impact of COGS on business financials

Let’s look at COGS effect on your financial reports and how it impacts your bottom line.

COGS’ effect on gross profit and net income

Your COGS directly impacts two categories in your business financials: gross profit and net income. 

Gross profit is what you get when you subtract COGS from your sales revenue. It helps indicate how efficiently materials are transformed into profitable products. A lower COGS means you keep more from each sale, boosting your gross profit.

Net income takes it further by subtracting operating expenses (like rent, utilities, and salaries) from your gross profit. Since COGS is a large part of your overall costs, keeping it under control can significantly affect your bottom line, making your business more profitable.

Importance of COGS management for improving profitability

Effective COGS management ensures that you are generating revenue and retaining a higher portion of it as profit. This includes reducing expenses and making wise investments to increase your profit margin. 

Relationship between COGS, inventory, and cash flow

Keeping the right amount of inventory is essential for your business. Too much inventory can tie up your cash and affect your cash flow. However, having too little inventory can lead to stockouts and lost sales. Finding the right balance will keep your cash flow healthy and your costs low without hurting your sales.

Strategies for managing and reducing COGS

Here are some strategic approaches to consider for managing and reducing COGS:

Purchasing strategies to lower input costs

1. Bulk buying: Purchasing materials in bulk often secures lower prices, reducing your per-unit cost. However, balance this with your inventory capacity and cash flow to avoid unnecessary stockpiling.
2. Supplier relationships: Build strong relationships with suppliers. Loyal customers often receive better prices, early access to sales, or flexible payment terms.
3. Alternative suppliers: Regularly seek quotes from alternative suppliers to ensure you get the best deal. This can also give you leverage in negotiations with current suppliers.
4. Group purchasing: Consider joining a buying group. Small businesses that buy as a collective can negotiate lower prices from suppliers.

Efficiency improvements in production and operations

1. Process optimization: Review and optimize your production processes regularly. Even small efficiencies can add up to significant cost savings over time.
2. Technology investments: Invest in technology that can automate repetitive tasks, improve accuracy, and speed up production. The initial cost may be high, but the long-term savings can be substantial.
3. Waste reduction: Implement strategies for reducing waste materials and improving yield. Every bit of material not wasted is a direct saving.
4. Employee training: Well-trained employees work more efficiently and make fewer costly mistakes. Invest in training to improve skills and productivity.

Outsourcing and negotiation tactics with suppliers

1. Outsourcing: Sometimes, it’s cheaper to outsource certain production stages or components to specialized providers. Evaluate the costs and benefits of outsourcing non-core activities.
2. Negotiation skills: Effective negotiation with suppliers can lead to better prices, quality, and payment terms. Be informed about market prices, and don’t hesitate to negotiate.
3. Long-term contracts: Locking in prices with long-term contracts can protect you from price fluctuations. This requires a good relationship with the supplier and a clear understanding of your long-term needs.
4. Volume discounts: If your business has grown, renegotiate prices based on increased order volumes. Suppliers are often willing to offer discounts to retain high-volume customers.

Implementing these strategies requires a careful balance. Ensure that cost-cutting measures maintain the quality of your products and your business’s operational efficiency. 

Continuous improvement in managing COGS can lead to better pricing strategies, improved margins, and a stronger competitive position in the market.

COGS and pricing strategies

Your (COGS) is essential when setting prices for your products. It represents the lowest price you can charge without losing money on each sale.

How COGS influences pricing decisions

Knowing your COGS helps you set a price that covers your costs and includes a profit margin. If your COGS increases, you might need to raise prices to maintain your profit margin. 

Competitive pricing: This strategy involves pricing your products based on competitors’ charges. Stay competitive, but be careful not to price so low that you barely cover your costs or go below them. Finding the right balance between being competitive and making a profit is essential.

Cost-plus pricing: This model adds a fixed margin to your COGS to ensure a profit. For example, if your COGS for a product is $10 and you want a 50% profit margin, you’d price it at $15. This method ensures you cover your costs and make a profit, but be mindful of how your prices stack up against competitors. Too high, and you might price yourself out of the market.

Balancing quality, cost, and pricing to maximize profits

Maximizing profits could mean slashing costs to lower your prices. Sometimes, it’s about offering better quality that justifies a higher price. Here’s how to balance the three:

Understand your customers: Know what your customers value. Suppose they’re willing to pay more for higher quality. In that case, it might be worth increasing your COGS to provide a superior product.

Monitor your costs: Keep a tight lid on your COGS without compromising quality. Look for efficiencies in production or sourcing, but be wary of cuts that could hurt your product’s value.

Adjust your pricing strategy: Depending on your market position and customers’ preferences, decide whether a competitive or cost-plus pricing model makes more sense. Sometimes, a mix of both in different business segments might work best.

Remember, your goal is to find a sweet spot where your prices cover your costs, including COGS, while also appealing to your customers and keeping you competitive.

COGS in different business environments

Your type of business will change how you manage your COGS.

Variability of COGS in service vs. product-based businesses

Up to this point, we have covered COGS for product-based business. If you sell products, COGS includes raw materials and labor for making those products. 

If you offer services, COGS covers the salaries of people providing the service, the cost of utilities, and any materials used. Service COGS can be trickier, depending on how efficiently your team works.

Impact of industry standards and practices on COGS

What’s expected in your industry can affect your COGS. High-quality standards mean higher costs for better materials and skilled workers. But, if you focus on selling more for less, you might save money by buying in bulk. For businesses in regulated fields, costs for meeting safety or environmental rules will also be accounted for in COGS.

Using strategies like just-in-time (JIT) inventory can help keep COGS down by cutting storage costs. JIT would need tight planning with your suppliers to avoid running out of what you need.

Accounting practices and COGS

Accounting practices are the processes and methods used to record, report, and analyze financial information within an organization. This can include bookkeeping, financial reporting, and internal controls.

Inventory valuation methods and their impact on COGS

The method you choose for inventory valuation can significantly affect your COGS. Here’s how different methods impact COGS:

• FIFO (First in, First out): This method assumes the first items added to your inventory are the first sold. In times of rising prices, FIFO will result in lower COGS and higher gross profit because the older, cheaper items are sold first.
• LIFO (Last in, First out): LIFO assumes the most recently acquired items are sold first. During periods of inflation, LIFO leads to higher COGS and lower gross profit, as the cost of newer, more expensive inventory is accounted for in COGS first.
• Average cost: This method calculates COGS based on the average cost of all items in inventory over the period. It smooths out price fluctuations, offering a middle ground less sensitive to price changes than FIFO or LIFO.

The choice among these methods affects how COGS is reported and can influence financial outcomes such as gross margin, tax liabilities, and net income.

Implications of accounting standards (GAAP, IFRS) on COGS reporting

• GAAP (Generally Accepted Accounting Principles): In the U.S., GAAP allows the use of FIFO, LIFO, or Average Cost methods for inventory valuation, directly impacting COGS calculation. The chosen method affects financial reporting and tax obligations.
• IFRS (International Financial Reporting Standards): IFRS, used in many countries outside the U.S., does not permit using LIFO. This can lead to differences in COGS and financial performance metrics when companies across different jurisdictions are compared.

Therefore, the accounting standards you adhere to can significantly impact how you report COGS, affecting your business’s apparent profitability and financial health.

Manipulating COGS: Legal and ethical considerations

Messing with your COGS to look better financially is illegal. Trying to show less profit to pay less tax or inflating your profit numbers can get you in trouble with the IRS. This would be damaging your business’s reputation.

Ethics and legalities

It’s super important to keep your COGS reporting straight. This means giving clear and honest financial information to everyone involved with your business, like investors, lenders, and the tax folks. There are strict rules and accounting standards to ensure businesses report their numbers correctly.

Keeping COGS accurate

Getting your COGS right means understanding how to value your inventory correctly and knowing the accounting rules. Always approach COGS with honesty. Doing so isn’t just about avoiding trouble; it’s about earning trust. Accurate and transparent COGS reporting helps build a robust and trustworthy relationship with your business partners and supports your business’s growth over time.

Technological tools and software for COGS management

Thanks to modern technology, you’re no longer stuck doing everything manually. 

Overview of accounting and inventory management software

A wide array of accounting and inventory management software is designed to make tracking COGS simpler and more accurate.

Accounting software: Tools like QuickBooks, Xero, and FreshBooks can automate many aspects of financial management. They allow you to track expenses, sales, and inventory changes, directly feeding into COGS calculations. These platforms often come with dashboards that give you an at-a-glance view of your financial health, including COGS.

Inventory management software: Systems such as Zoho Inventory, TradeGecko (now QuickBooks Commerce), and InventoryLab focus more on the stock side. They help you track inventory levels, manage orders, and calculate COGS by keeping detailed records of purchases and sales. These tools can predict inventory needs, helping avoid surplus and stockouts.

The role of technology in tracking and optimizing COGS

Technology simplifies tracking COGS and opens up opportunities for optimization. 

Here’s how:

1. Real-time data: Digital tools provide real-time updates on your inventory and costs. This instant access to data means you can quickly adjust pricing, promotions, or purchasing to optimize your COGS.
2. Accuracy: Manual calculations are prone to errors. Automated systems reduce these risks by precisely tracking every transaction. Accurate COGS calculations ensure you price your products correctly, protecting your margins.
3. Trend analysis: Many software solutions offer analytics features that can show trends in your COGS over time. Spotting these trends can help you identify areas for cost reduction, whether through negotiating better prices with suppliers or identifying inefficiencies in production.
4. Integration: Most modern software solutions can integrate with other business tools, providing a comprehensive view of your operations. For example, connecting your inventory management system with your accounting software can automate the COGS calculation process, saving time and reducing errors.

Adopting technology for COGS management is manageable. Start with one tool that integrates well with your existing systems and offers the features most relevant to your business needs. As you become more comfortable, consider adding specialized tools or advanced features to optimize your operations.

Next, check out our articles on 18 best accounting software, apps & tools in 2024, how to do cash flow forecasting, and understanding nonprofit accounting.

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Author: Julia Kelly

Co-founder at Rigits

I write about how small business owners can better understand and utilize their financials for growth.

Julia Kelly