Understanding the Cost of Goods Sold

 

Being profitable means spending money on what needs to be sold, and the currency spent on the direct creation of the merchandise, which is then sold is known as COGS or cost of goods sold. The figure in question is a highly important piece when accounting is concerned, which is why accurate calculations of it are a must. It is also crucial for trading niche and stock markets. So, where exactly does this metric find its use?

 

Well, that and more will be looked at closely as we delve into what COGS is and how it's determined. Let’s also check why it's so vital for businesses and trading experts to know COGS!

Contents:

- COGS basics

- Operation and efficiency

- How it's determined

- Accounting it

- Other information and example

 -Final thoughts

COGS basics

Cost of Goods Sold (COGS) refers to the direct spending/costs that are associated with the production of the goods sold by a company. This includes the cost of the materials and labor used to create the product/service. It is also worse to mention that it does not include indirect expenses. So only the expenditure directly linked to the creation of the merchandise sold can accumulate and be placed under the umbrella in question.

 

Due to this other expenses loosely connected to these goods like what's spent selling and marketing them, won't be listed here (for example, distribution costs and sales force salaries). The same is true for anything not sold yet. Instead, the following are considered:

- Raw materials purchased

- The cost of labor

- The cost of manufacturing

Operation and efficiency

The figure found when all these things are tallied allows you to get a good look at how an operation is faring, as while higher costs may be advantageous due to income tax, it leads to lower payments to investors. This is why lower costs are perfect for their bottom line. Another cardinal reason for having this figure is its role in finding the gross profit of an operation — a figure that's also used to gauge the operation's efficiency.

 

Though useful, the problems related to COGS are worth pointing out, mainly seen through tampering by those with access who fudge the numbers. Some of the things they do to achieve this include overvaluing on-hand inventory, overstating discounts, as well as what's returned to suppliers, or simply not writing off the inventory deemed obsolete. Experienced investors looking to do their due diligence will always look at the numbers and they will easily tell when things are amiss, so always avoid any shady activity as a responsible organization.

 

How it's determined

COGS calculations require some level of account knowledge, especially as it pertains to the statements used. Income statements, for example, possess a cost of goods sold, an account where the inventory already sold will appear, and at the start of a year, it’s whatever remained unsold from last year. All things including what’s been discussed above and any new inventory are then added to it.

 

At the year's end, the inventory that hasn't been sold is removed from that total, leaving us with that specific year's COGS as the difference. What isn't sold carries over, becoming the inventory for the next year and thus, the cycle continues. Balance sheets typically have a current assets account, where this metric is seen in ending inventory.

 

Accounting it

While the above shows how to find the figure, it's important to know that various ways can be utilized to account for the cost of goods sold. This is due to the value depending on an operation's costing method and these are as follows:

• First in, first out (FIFO): this path is such that all merchandise made first are given priority and are thus sold before others, which reveals a net income that increases because of typical price increases
• Last in, first out (LIFO): this path is the complete opposite of the first path as the goods manufactured last are sold first, resulting in a net income that decreases during periods of increasing prices
• The special identification way: this way uses the particular cost of each unit, allowing businesses to know precisely what's sold and what it took to get it
• The average cost way: here, the value of goods is taken irrespective of their manufacturing or purchasing dates, instead, using what's in stock and its average price
  
  

Other information and example

The cost of goods sold is a necessary calculation for all organizations except those providing services as they typically have no inventory. Another thing to remember is that it shouldn't be confused with the cost of revenue, which refers to the contracts of services and labor yet to be utilized.

 

Let’s take for example commodities, the Cost of Goods Sold for them encompasses the expenses directly related to their creation or purchase. For commodities manufactured by a company, COGS includes the cost of materials, labor, production spending, etc. For commodities bought from another company, COGS covers their buying price, shipping costs, and any expenses for processing. The specific components of COGS can vary greatly, depending on the type of commodity and the industry it belongs to.

Final thoughts

Suffice it to say, the Cost of Goods is an important figure, as the above has shown and it's used to tell how an organization is doing in not only the part of the business but also for potential investors looking to gauge viability.

 

As such, businesses have to be careful with how they calculate the numbers so as not to garner any suspicion. Regardless, there are many ways to go about accounting for this cost, and with it comes its use in finding the gross profit, which is another important metric. So, always be careful when it comes to these calculations and what's used to get them because it matters!

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