There are dozens of metrics you can track to measure the health and success of your business, and it’s overwhelming to understand the differences between the “nice-to-track” metrics vs. the “must-track” metrics. In the case of Cost of Goods Sold (COGS), though, we’re talking about a must-track metric.
COGS consists of all of the direct costs involved in manufacturing and selling products–which ultimately affect profits.
Understanding COGS and optimizing it can mean the difference between scaling a business profitably and running a short-lived business.
What Is Cost of Goods Sold (COGS)?
Cost of Goods Sold (COGS, i.e., the cost of sales) refers to the direct costs incurred by a company while manufacturing and selling its products.
How To Calculate COGS
Cost of goods sold can be calculated in a number of ways, but we recommend using a two-part formula.
First, from a given time period, calculate your cost of goods available by subtracting COGP (cost of goods purchased) and/or COGM (cost of goods manufactured) from your initial inventory value.
- Initial inventory value: the total potential revenue (excluding discounts) of your inventory that has rolled over from the previous time period (previous month/year/etc.)
- Cost of goods purchased and/or cost of goods manufactured: cost of items bought or produced during the current period
Then, subtract your end inventory value from cost of goods available, and you’re left with cost of goods sold.
- End inventory value is the total potential revenue of the inventory that wasn’t sold during in the period
Important note: You can use the formulas to calculate your cost of goods sold, for your entire inventory, a product line, a SKU, or any other inventory breakdown.
What Is Included in Cost of Goods Sold?
COGS includes all the direct costs incurred by a company when it manufactures products. Some are variable costs like labor and storage costs, while others are fixed costs like insurance and utility bills.
Examples of costs generally used in COGS include:
- Raw materials
- Freight-in costs
- Purchase returns and allowances
- Trade or cash discounts
- Factory labor
- Parts used in production
- Items purchased for resale
- Inventory storage costs
- Factory overhead
An Example of Calculating COGS
Let's assume a consumer product brand starts 2022 with $30 million in beginning inventory (the ending inventory balance from 2021).
Throughout 2022, the brand purchases $15 million in additional inventory and fails to sell $10 million in inventory.
With that said, the COGS in 2022 can be calculated with the following formula:
COGS = $30m + $15m – $10m = $35m
Using your COGS figure, you can then calculate your gross profit. The calculation for gross profit is revenue - COGS:
In this case, if the brand has $90m in revenue, then the gross profit is $55m.
How COGS Fits Into Your Business
Calculating your brand’s cost of goods sold is crucial because it measures the actual costs of producing products, as the direct costs have been subtracted.
You’ll have a clear measurement of the costs of producing products as well as your inventory turnover–and, as a result, you can optimize pricing.
Generally speaking, you can expect your COGS to grow alongside revenue. The more products you sell, the more is spent on production (COGS may not grow as quickly as revenue if, for example, your POs are larger and you get volume discounts).
How COGS Affects Pricing
Pricing your products "correctly" is one way to ensure your business is set up for success. COGS is vital to pricing because it lets you know if you're undercharging or overcharging for your products.
If your products are priced too high, you might see a decrease in sales. If prices are too low, you won't make a profit.
For example, let’s say your COGS for Product X is $30. You have to price the product higher than $30 to make a profit. If you price it for less than $30, you lose money. Simple, right?
COGS is valuable because it helps you find the "sweet spot" when pricing your products: you can choose pricing models that result in a healthy profit margin.
For example, Caraway, one of our customers, optimized pricing during a product launch due to high COGS.
Not everyone wants to reduce their prices if their customers are happily paying full price for products, but reducing your prices with COGS in mind is a great way to grow your customer base while still being profitable.
How COGS Affects Costs
COGS lets you know if you're spending too much on manufacturing and production costs. The higher your manufacturing costs, the higher you need to charge for your products to profit.
If your production costs are high, you can find ways to cut down costs, such as finding a new supplier, changing materials, or increasing Order quantities.
How COGS is Used in Other Formulas
COGS is used to calculate two other vital metrics:
- Inventory Turnover: Shows how many times a business sells and replaces its inventory. It's a reflection of production level and sell-through.
- Gross Margin: Your net sales minus the cost of goods sold (COGS)
How COGS Differs From Cost of Revenue and Operating Expenses
COGS is often confused with Cost of Revenue and Operating Expenses (OPEX). While these terms have a few things in common, there are some key differences.
Cost of revenue vs. COGS
Cost of revenue is a more robust calculation. Cost of revenue includes all COGS components, and it factors in direct costs like sales commissions, sales discounts, distribution, and marketing costs.
Service businesses mainly use cost of revenue, while COGS is primarily used by companies selling physical products. However this doesn’t mean that products businesses can’t use cost of revenue and services businesses can’t use COGS.
Like COGS, the cost of revenue excludes indirect costs like salaries that aren't attributed to a sale.
Operating expenses (OPEX) vs. COGS
"Operating expenses" is more of a catchall term, and it’s thought of as the opposite of COGS. Operating expenses focus on running a business but not the costs of producing products.
Operating expenses include selling, general, and administrative (SG&A) expenses such as insurance, legal and accounting fees, travel, taxes, and office supplies. Excluded from operating expenses are COGS items and non-operating expenses, such as interest and currency exchange costs.
How Your Inventory Accounting Method Affects COGS
COGS varies depending on the inventory methods you use. The four inventory methods include:
- FIFO (first in, first out): The first items made or purchased by the brand are the first products sold. Your inventory cost is based on your oldest inventory.
- LIFO (last in, first out): The most recent products made or purchased by the brand are the first products sold. Your inventory cost is based on your newest inventory.
- Average cost: Calculates the average cost per item
- Special Identification Method: Used for unique or high-ticket items
The inventory method you use depends on your type of inventory. For example, you'll likely use FIFO if you sell food because you want to sell the older products closer to expiring first.
The FIFO method focuses on selling the products you purchased or manufactured first. Because product prices increase over time, you sell your least expensive products first. As a result, you’ll record a lower COGS.
So, the net income using the FIFO method increases over time.
With the LIFO method, you sell the most recent goods you purchased or manufactured. With LIFO, your COGS might be higher than FIFO.
With LIFO, if your prices are already high or steadily rising, the products sold first lead to a higher COGS. So over time, your net income is lower. There are many nuances with the LIFO method–it may not seem like a great option compared to FIFO, but it has its uses: for example, it can be used in the face of rising costs.
Average Cost Method
With the average cost method, you take an average of your inventory to determine the cost of goods sold. This keeps your COGS more level than the FIFO or LIFO methods.
Using the average cost method has a unique effect in that it prevents COGS from being impacted by excessive production costs. For example, if the average cost of most of your products is between $40-$50, one product with a cost of $400 will wildly affect your COGS with other inventory methods. However, if you’re using the average cost method, the expensive product will barely move the needle.
Special Identification Method (SIM)
The special identification method calculates the specific cost of each individual product to determine the ending inventory and COGS.
For example, with LIFO, Product X might cost $5000, which applies to each unit of Product X produced. With SIM, the individual cost for each unit of Product X is accounted for. So instead of a base of $5000 per unit, the cost can vary depending on specific variables around each unit.
SIM is used for businesses to check which item was sold and the exact cost. SIM is typically used in industries that sell unique items like cars, real estate, and jewelry.
How Daasity Makes Commerce Analytics Easier
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