The term “cost of goods sold” can tell you a lot about a business’s financial health. Knowing it, you can calculate the gross margin profit. So, what is the Cost of good sold? Why is it important?
What Is The Cost Of Goods Sold (COGS)?
The Cost of goods sold (COGS) is the total costs directly tied to the production of the goods already sold to customers.
Another name for the Cost of goods sold is the Cost of sale. It includes all expenses directly attributable to the process of producing the goods or services in a specific accounting period. These costs consist of direct labor, direct material, and direct overheads. The Cost of goods sold excludes indirect overhead expenses related to the business’s overall operation, such as marketing, administrative, or selling expenses.
The Cost of goods sold appears in the company’s income statement right after the generated revenue. By subtracting it from the total revenue, we have the business’s gross margin for the reporting period.
The Cost of goods sold is reported in the income statement.- Source: corporatefinanceinstitute.com
Cost Of Goods Sold Vs. Cost Of Goods Available For Sale
Firstly, let’s differentiate the goods available for sale and goods sold: Goods available for sale can be understood as all inventories ready for customers. Meanwhile, goods sold are the few items already sold to customers.
Therefore, the volume of goods sold usually is less than the goods available for sale. As a result, the total cost of goods available for sale is more significant than that of goods sold since the cost for each good unit is the same in most cases.
Implications Of The Cost Of Goods Sold
Setting The Price Of The Product
In almost all cases, You should control pricing policy based on a Gross Profit Margin Target (GPMT) strategy in almost all cases. Typically, companies wish to gain a high gross margin to pay back their operating expenses and generate positive net income. Once they know the Cost of goods sold, the price to achieve the desired Gross Profit Margin will come in handy.
In a straightforward formula, we have:
Gross Profit Margin = (P-C)/P Where: P – the price of the product.
C – The Cost of goods sold
If you keep up with the changes in the Cost of goods sold, you can easily define the price that will hit the targeted Gross Profit Margin.
Indeed, companies in different industries aim at different GPMTs. According to Business Insider, manufacturing companies need a GPMT of 50% while distributors require a GPMT of 10-15%. It will be a piece of cake to set the price if these companies know the Cost of goods sold.
More importantly, analysts and investors can base on the Cost of goods sold to diligently analyze the company’s profitability in more aspects for smart investment decisions.
Finding Business Profits
If you know the Cost of goods sold, you can quickly figure out your business’s gross profit. By deducting total expenses from your gross business profit, you can have the bottom line or net income.
Here are the formulas:
Gross profit = Total revenue – COGS
Net profit = Gross profit – Total Expenses
In short, the Cost of goods sold is an essential part of calculating the business profits. Knowing your business profit is the key to making the right business decisions and implementing appropriate financial policies.
Calculation Methods For The Cost Of Goods Sold
The Cost of goods sold varies considerably based on different accounting methods for the inventory valuation. Very briefly, we have four methods for calculating the Cost of goods sold. They are:
First in, first-out (FIFO): the oldest items you manufacture or purchase are recorded to be sold first.
Last in, first out (LIFO): The method records the newest items a company manufactures or orders to be out first. When the price escalates over time, companies with large inventories such as retailers can use LIFO to lower their short-term taxes.
Average Cost: Cost of goods can fluctuate much. Thus, this accounting method can smooth out the price fluctuation so the income statements in consecutive periods will show more precise profits, especially when the cost of goods fluctuation is only a temporary phenomenon. The average cost for all goods available for sale will be applied to the cost of goods sold.
An average Cost = Cost of all goods available for sale / total number of items available for sale
Cost of goods sold = Average cost * items of goods sold
Specific Identification: Clearly, the value and cost of the goods sold are easiest to determine when these goods’ costs are determined by their unit cost at the purchase/production time. Usually, manufacturing or merchandising companies with high-priced inventory will apply this method.
An Example For Calculating The Cost Of Goods Sold
For instance, consider the following inventory status of Company A in January, Year N:
|Purchase date||Number of items||Cost per unit||Total cost|
Assume that the company sold 15 units on 16th January. Look at the value of the Cost of goods sold from different calculation methods as below:
FIFO: The cost of goods sold = 12*$2,000 + 3*$1,800 = $24,000+$5,400=$29,400
LIFO: The cost of goods sold = 10*$1,700 + 5*$1,800= $17,000+$9,000 = $26,000
An average cost per unit = $68,000/ 37= $1,838
The cost of goods sold = 15* $1,838= $27,570
Specific Identification: suppose that, on 16th January, the company sold 15 units purchased on 10th January. We have the Cost of goods sold is the total purchase cost of these units ($27,000).
In short, the Cost of goods sold is one of the crucial indices, mainly affecting a business’s profits. It deserves much attention and an accurate calculation to evaluate precisely how effectively the firm manages its running Cost in the production process.
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