What the Heck is Cost of Goods Sold?

I swear that the Cost of Goods Sold (COGS) is not as hard as you would imagine.  It’s frustrating because you’re trying to figure out where to put your expenses, is it Overhead, is it COGS, what the heck? I know you’ve been trying to search through google and the articles are confusing.

And they make you do MATH.

Ok, you may have to do a little math, but I promise it won’t be as bad as you think.  And with a spreadsheet, it will be super simple.

But before we delve into the math let’s figure out what exactly it means.

I think Investopedia was put on this earth just for me.  They always have simple, easy explanations for even the most complicated topics.  If you’ve never heard of them, you should go, and bookmark the site right now.

Let’s take the definition and break it down.

Cost of goods sold (COGS) refers to the direct costs attributable to the production of the goods sold in a company. This amount includes the cost of the materials used in creating the good along with the direct labor costs used to produce the good. It excludes indirect expenses, such as distribution costs and sales force costs.

The Accounting Formula for COGS goes something like this….

COGS = Beginning Inventory + Purchases during the period – Ending Inventory

So, what does that gobbly gook mean for you?  To make it make sense to you need to know what type of business you have. Are you a retailer with a brick-and-mortar store, a wholesaler that sells to retailers, or do you have a service-based business?

Since most of COGS has to do with inventory, we’re going to start with an example of a company that produces coffee tables.

Let’s say you are a wholesale producer of a coffee table.  You buy raw materials like lumber and nails. and build a coffee table and sell it to a retailer.  Your cost of goods would look a little like this…..

At the beginning of the Month, this is the raw materials you have on hand and what you bought it for.

Beginning Inventory

4 Pieces of Cedar Wood for $100.00

1 Box 50 of Nails $10.00

During the month you bought this.

1 Box of Nails for $10.00

5 Pieces of Cedarwood

Let’s plug in the numbers

Your COGS for all your products is $95.00.

Now let’s say you want to know how much inventory you used for each coffee table.  (Not an exact science unless you are keeping track.  Just the number of coffee tables you sold by the COGS for May

For example

You sold 5 coffee tables

$75.00/5 = $15

For every coffee table, your cost of goods sold is $19.00.  Enter that into the profit tracker and you’ll easily be able to see how your costs are keeping up.

This example is just for raw materials and doesn’t consider freight or labor costs.  Now if you want to add the freight cost you can do it by either a single line item or you can add it to the price per unit.

What do I mean by freight you ask….

I’m talking about what the supplier charges you to ship the raw materials to you.  Generally, this is a line item on the bill.  For a longer explanation check out this article on Freight charges.

Make sure that when you enter the line item in your expenses as it is a COGS. Category.

Now that we understand what COGS is when producing a product what other charges besides raw inventory and freight should be considered?

There are some labor costs that may be tied directly to the production of your product.  Let’s say that again with an example.

Let’s say your company not only builds coffee tables but you have a factory and in that factory there are employees.  Inside your factory you have

1 Office Manager

2 Factory Workers

The factory workers actually build the product so their wages are considered COGS as well.  However, the Office Manager is considered an overhead expense (hey s/he might be awesome but for accounting purposes, they are overhead).

Let’s take a second example of a service-based business.  Heck let’s use my accounting business (just for fun).

We employ

1 Administrative Assistant

1 Bookkeeper

The bookkeeper only works on my clients’ business so s/he wages would be considered COGS. But the Administrative Assistant is considered overhead.

Now if I wanted to I could break this down even further and if we keep track of the Bookkeeper’s hours we can use the portion of the time that is spent on clients’ work as COGS and the remainder would be under overhead expenses.  This way only the time worked would be distributed to COGS and other times like education and training would be considered overhead.

Still unclear?  No worries if you want more information on Direct Labor check out our Block post Do You Know What Your Direct Labor is Costing You?

Let’s talk shipping.  If you own an e-commerce store and ship products to your customer, then you may be able to track the cost to ship to your COGS.  Let’s use our coffee table example to go a bit further.

Our company sells coffee tables in a Shopify store.  We decided that we would make shipping free to our customers.  So whatever the shipping costs to our customer we can add this to our COGS.  I would normally just add a line item on my expenses for each sale and then Average them for the month and divide them by the number of sales.  That way you can forecast approximately how much shipping will be for every unit sold.

Shipping = Total Shipping Costs/Total Sales

Now if we charge the shipping costs to the customer this would be basically a 0 line item or what we in accounting like to call a Pass-Through account which means we keep track but the line item should always be 0.

Now if we charge shipping costs to the client above the actual costs to ship the product (also known as a Markup) That actually becomes a product in itself and you’ll want to keep track of it.

Oh no your supplier raised their prices now how do you figure your cost?  The above example when we were talking about raw materials is considered the AVERAGE Cost but we have a couple of others.

Let’s use our above example

Before the supplier raised their prices the cost of Cedar Lumber was $25.00

After the supplier raised their price the cost of Cedar was now $50.00 we bought 4 more.

Before raised their price  4 X25 = $100.00

After the supplier raised their prices the 4 X 50 = 200.00

The average cost is the most straightforward.  You’d look at all the inventory purchased and figure out the average cost for the wood.  Total up your inventory and divide by the number of units and you have the average cost.

300/8 = $37.50 unit price for Cedar

FIFO assumes that the coffee table that you built uses the first order of lumber before it will use the second.  Under this rule, you use the last price that the supplier charged you which means your per-unit cost would be $50.00.

FIFO is used during times of rising prices because costs are recorded as lower and income is then recorded as higher.

With LIFO we assume that the first pieces of lumber you use are the last pieces of lumber that you purchase.  Since you used up that you used 2 units at $50.00 each and the next 2 units would be at $25.00.

LIFO is used mainly during times when tax rates are high because costs assigned will be higher and income will be lower (which gives you a bigger break on your taxes.).

Notes:  It can be difficult to select a cost method, and there are certain guidelines that the IRS provides that you used 2 units at $50.00 each and the next 2 units would be at $25.00.

We’ve covered a ton of information.  From defining what Cost of Goods Sold is to writing up examples of how it can be used for your business.  I hope that you’ve found the information useful.  I know that calculating COGS can be difficult but keeping track of your costs is one of the most important things a small business owner can do.  Just keep in mind that most accounting software will keep track of your COGS for you and of course, we can calculate that for you if you need some help.

As Always if you have questions or need a consultation you can always talk to us.

Cheers!

Andrea