COGS serves as a vital indicator of the direct expenses incurred in producing goods for sale. This includes the cost of materials, labor, and other expenses directly related to creating the product. COGS do not include indirect expenses such as overhead, rent, or salaries of non-production staff.
The formula to calculate COGS is:
Beginning Inventory + Purchases – Ending Inventory = COGS
Calculating COGS involves a few key components:
- Beginning Inventory: This is the value of your inventory at the start of the accounting period.
- Purchases: Include the cost of materials and any other direct costs incurred during the accounting period. This also includes the cost of labor directly involved in producing the goods.
- Ending Inventory: This is the value of your inventory at the end of the accounting period.
Here’s how to calculate COGS step by step:
- Step 1: Determine your beginning inventory. This is the total value of your inventory at the start of the accounting period. You can find this value in your previous accounting records.
- Step 2: Calculate your purchases. Add up all costs directly related to producing your goods, including the cost of materials and direct labor.
- Step 3: Calculate your ending inventory. This is the total value of your inventory at the end of the accounting period.
- Step 4: Use the formula to calculate COGS:
COGS = Beginning Inventory + Purchases – Ending Inventory
For example, if your beginning inventory was $10,000, purchases during the period were $5,000, and your ending inventory was $4,000, your COGS would be: $11,000
Why is COGS important?
Monitoring COGS allows you to identify inefficiencies in your production process. By pinpointing areas where costs are high or rising. If COGS increases, then the net income will automatically decrease!
There are several accounting methods for calculating Cost of Goods Sold (COGS), with the most common being:
- FIFO (First-In, First-Out): By employing the FIFO method, businesses prioritize selling their oldest inventory first. As prices often rise over time, this approach means that cheaper goods are sold first, leading to a lower Cost of Goods Sold (COGS). Consequently, over time, net income tends to increase under FIFO due to the favorable impact on COGS.
- LIFO (Last-In, First-Out): LIFO assumes that the most recently purchased or produced items are the first to be sold. This method matches the cost of goods sold with the cost of the newest inventory on hand, leaving older inventory in stock.
- Weighted Average Cost: This method calculates the average cost of all units available for sale during the accounting period and applies this average cost to the units sold.
- Specific Identification: With this method, the actual cost of each item sold is individually identified and used to calculate COGS. This method is typically used for unique or high-value items.
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