Cost of goods sold (COGS): Why It Matters, How to Calculate It

Cost of goods sold (COGS) is all costs the company incurred in producing goods and providing services. It consists of labor costs, raw materials, overhead, finished goods inventory costs.

COGS covers most of the company’s expenses. The value is also variable and follows the volume of products the company produces.

The company usually presents it in the second line after revenue in the income statement. For public companies, you can also see full details of COGS calculations in the notes of the audited financial statements.

How to calculate the cost of goods sold

You can calculate the cost of goods sold by subtracting the beginning finished goods inventory from the ending finished goods inventory and then adding the result to the finished goods’ purchases during the reporting period. Or if it is presented in a mathematical equation, the formula for the cost of goods sold is as follows:

COGS = Initial inventory – End inventory + Purchases

For example, a company reports an initial inventory of Rp100 a year and purchases of Rp20. At the end of the year, the final inventory is Rp90. Hence, the COGS value is IDR 30 (IDR 100 – IDR 90 + 20).

One more example.

A company reports the direct costs associated with production as follows:

To solve the above case, you calculate the cost of goods sold as follows:

COGS = Beginning finished goods inventory + Cost of goods manufactured – Ending finished goods inventory

Since the company also bought the finished goods for IDR600, you must add it to the formula above. Meanwhile, to calculate the cost of goods manufactured, you can use the following formula:

Cost of goods manufactured = Total manufacturing cost + Work in process inventory at the beginning of the year – Work in process inventory at the end of the year

Where the total manufacturing cost is equal to the sum of direct material costs, direct labor, and factory overhead.

So, we can solve the above case as follows:

What is included in the cost of goods sold

COGS only includes costs directly related to the production of goods. It doesn’t cover indirect costs such as sales expenses, administrative expenses, and general expenses.

COGS’ composition can vary depending on the company’s product. For example, service companies don’t have inventory related to service provision. And. for manufacturing companies, they have it.

Although most COGS includes variable costs, there are also fixed costs, such as factory overhead. Sometimes, depreciation costs also fall into this category, but it depends on each company’s accounting policies.

In short, COGS usually covers costs such as:

• Raw material costs (+)
• Direct labor costs (+)
• Costs of purchasing inventory goods (+)
• Overheads such as electricity, water, and rent (+)
• Transportation fee for purchase (+)
• Purchase returns and discounts on input prices (-)
• Discount (-)

A plus sign means adding COGS, a minus sign means reducing it.

How the cost of goods sold affects company profits

To get gross profit, you need to deduct sales revenue with COGS. An increase in COGS decreases the company’s gross profit, which, in turn, lower the gross profit margin.

Gross profit margin is the ratio between gross profit to sales revenue. It is a useful metric to evaluate the efficiency of a company’s production. Ideally, the company posted a high margin, showing the company posted a revenue large enough to cover the direct costs of production.

After covering direct costs, the company also needs to pay operating expenses (sales, general and administrative expenses). Hence, assuming other expenses are constant, the increase in COGS reduces not only gross profit but also operating profit and net profit.

How inventory affects the cost of goods sold

As you can see from the formula, the COGS value depends on the difference between the initial and ending inventory values. Furthermore, the value of inventory also depends on the accounting method in reporting it. Each has different consequences when the price of goods changes. Three methods for measuring inventory are:

1. First-in, first-out (FIFO)
2. Last-in first-out (LIFO)
3. Weighted average cost (WAC)

The FIFO method assumes the earliest item purchased is the first one sold. So, the final inventory comprises the most recent purchases. If the price rises, the value of the ending inventory will be higher. Hence, the COGS value will be lower.

For example, at first, you buy raw materials for Rp50. Then, you buy it again at the price of Rp60. Under the FIFO method, you use the last price, Rp60, to calculate the final inventory. As a result, COGS values ​​will be lower.

In contrast, the LIFO method assumes the most recent purchases are sold first. The ending inventory will only contain the earliest purchases. For the example above, you use the first price, Rp50, as the final inventory calculation. As a result, COGS values ​​will be higher.

Meanwhile, under the weighted average cost, you allocate inventory costs equally across all units. The COGS value will be between the FIFO and LIFO.

In short,

• If the price goes up, the COGS value: LIFO> WAC> FIFO
• If the price drops, then the COGS value: FIFO> WAC> LIFO

How to reduce the cost of goods sold

Input purchase discount. If the company buys raw materials on a large scale, the supplier will usually offer a price discount. Discounted price means lower input costs. Such discounts are also common for shipping large quantities of goods.

Companies also get lower prices by securing long-term supply agreements or paying suppliers on time.

Adopting more advanced technology and production methods. Automation and mechanization enable companies to reduce labor costs. It saves costs while also increasing productivity. Likewise, methods such as just in time and lean production also contribute to lower COGS.

Switch to cheaper or better quality inputs. Using higher-quality inputs reduces costs such as inspection of input quality and avoids machine jams.

Cheaper inputs, of course, result in lower COGS. But, companies must ensure that it does not reduce the quality of output.

Relocate production facilities. Outsourcing to low-wage countries is another alternative to reduce COGS. The company can also move its location near the center of raw materials, thereby reducing transportation costs.