Here, we breakdown everything you need to know about the importance of calculating Cost of Goods Sold (COGS) to determine product pricing strategy and how to maintain a healthy profit margin.
What is the cost of goods sold?
COGS is the value of the inventory that has been sold by a business. It is only recognized upon sale of inventory and is reported in the financial period in which those sales occur.
The value of inventory is the total of the direct cost of the products making up that inventory, which has either been produced or purchased by a company for resale. It includes additional charges directly related to preparing products ready for sale, like packaging and delivery charges. However, it excludes indirect expenses such as sales and marketing.
Therefore, COGS equal the direct cost related to the production of or purchase of products sold.
Keep in mind that the value of inventory on hand is considered an asset until the inventory is sold.
Why is it important to calculate the cost of COGS?
The primary motive of starting any business is to earn a profit. A business can ensure it earns a profit by knowing the exact income and expenses incurred to sell its products.
COGS inform a business about all the direct expenditures incurred in getting products ready for sale. Therefore, COGS are an important part of the business decision making process.
Here are some of the benefits of calculating COGS:
No. 1 — Helps create a pricing strategy
The selling price of products can be determined by knowing the total direct costs incurred in producing or procuring products. Once these costs are established, businesses are in a better position to judge the price at which to sell products to cover indirect expenses and also earn a profit from the sale.
Knowing COGS helps determine a profit margin on the products for sale.
No. 2 — Helps determine the total expenses incurred in selling products
A profit and loss statement needs to list all income and expenditures. By taking the direct costs spent in acquiring stock, you can arrive at the total expenses incurred by including other indirect expenses such as overhead costs like sales and marketing.
No. 3 — Compare the market value of your product with your competitors
Determining profit margin by only considering direct costs incurred is an incomplete picture. Chances are that a company’s prices may be higher than their competitors in the market. In such a situation, fewer customers will buy at the higher price.
However, if a business sells at prices lower than the competition, a loss may still be incurred since a low profit margin may not cover indirect expenses.
COGS helps a business to sell products at a competitive price, grow sales and by extension, earn profits.
How to calculate COGS
Here’s the formula to derive COGS:
- COGS = Beginning Inventory + Purchases made during the period – Ending Inventory
- To calculate the COGS for a reporting period, start with the value of the beginning inventory.
- If additional inventory was added during the reporting period, be sure to add the value. of any new inventory that is produced or purchased to the value of the existing stock.
- Now, subtract the value of ending inventory from COGS sold for the reporting period.
Note: This is a basic example and does not take into account items like returns, discounts, obsolete stock and the inventory valuation method used.
Example of COGS
Let’s assume that Company X uses the calendar year to record their inventory. The beginning inventory value was recorded on Jan. 1 and the ending inventory value was recorded on Dec. 31.
The beginning inventory value was $20,000. During the year, the retailer realized that the business would sell more than the inventory received earlier in the year, so additional inventory worth $7,000. was purchased.
At the end of the calendar year, the ending inventory value was worth $4,000.
Now, let’s work out the COGS for the entire year by using the formula.
COGS = Beginning Inventory + Purchases made during the period – Ending inventory
COGS = $20,000 + $7,000 – $4,000
Therefore, COGS = $23,000
The COGS equals $23,000, as calculated. Use this formula to help with production, purchasing, and pricing decisions.
Calculating COGS can assist in calculating overall profit for a reporting period and help with decisions to ensure that indirect costs are covered.
Suppose revenue is $75,000 in a reporting period.
Knowing the COGS, profit will equal $75,000 – $23,000 = $52,000
COGS – Key business takeaways
The COGS formula can be used at an individual product level to help with decision making prior to producing, procuring, and selling that product.
The COGS for a reporting period is the total of COGS for all product sales for that reporting period. It is a vital metric that is included in financial statements and is used to calculate gross profit for that reporting period. Gross profit is a profitability measure that shows how well a business can cover its indirect expenses and earn a profit.
The value of COGS will always depend on the direct costs of the products sold and the inventory valuation method used by the business.
Mark Leach is the Manager of Content/Web Enablement for Product Marketing at Cin7.
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