What is COGS?
Cost of Goods Sold (COGS) is a term commonly used in accounting and finance to refer to the direct expenses incurred in the production and sale of a product. It includes the costs directly associated with manufacturing and delivering a product to customers.
Understanding COGS is crucial for businesses as it aids in determining the profit margin, which serves as an indicator of financial performance. It’s worth noting that COGS excludes indirect costs like marketing and distribution expenses.
Components of Cost of Goods Sold
According to AASB 102, following are the main components COGS that must be considered:
- Direct Costs: These are costs directly associated with the production of goods, including raw materials and direct labour costs. Direct costs are integral to the creation of a product and vary proportionally with the level of production.
- Production Overheads: Overheads related to the production process, both fixed and variable, are also included in the cost of sales. Fixed production overheads, such as depreciation and maintenance of factory buildings and equipment, remain relatively constant regardless of production volume. Variable production overheads, like indirect materials and labour, fluctuate with production levels.
- Unallocated Overheads and Abnormal Costs: The document specifies that unallocated production overheads and abnormal amounts of production costs are recognised as expenses in the period they occur, contributing to the cost of sales. These may include costs that exceed the normal production costs due to inefficiencies or unexpected expenses.
- Distribution Costs: Depending on the entity’s circumstances, distribution costs may also be included in the cost of sales. These are costs associated with delivering the product to the customer, including shipping and handling expenses.
Which Expenses Are Excluded from COGS?
Cost of Goods Sold serves as a vital financial metric, reflecting the direct costs involved in manufacturing and selling a product. However, it’s important to recognise that several types of expenses are not factored into the COGS calculation:
Indirect Expenses:
These are costs not directly linked to product production, including expenses like marketing, research and development, and general administrative overhead.
Selling Expenses:
Costs associated with the sales process, such as sales commissions, shipping fees, and customer service expenses, are not considered part of COGS.
General and Administrative Expenses:
These encompass various operational costs like rent, utilities, insurance, and legal fees, which are not directly tied to product production or sale.
Depreciation and Amortisation:
These non cash expenses represent the decrease in value of long-term assets like buildings, equipment, and patents, and are not factored into COGS. According to AASB 116, they are considered as expense that are allocated over the useful life of the asset, impacting the entity‘s profitability but not directly related to the production of goods.
Losses from Damaged or Obsolete Inventory:
If inventory becomes damaged or obsolete, the associated costs are not included in COGS; instead, they are recognised as losses on the income statement.
By excluding these expenses from the COGS calculation, a clearer understanding of an entity‘s gross profit margin and overall financial performance is achieved.
How To Calculate COGS
The cost of sales is calculated by adding the direct costs of producing goods to the allocated overheads. It is important to include costs previously included in the measurement of inventory that has now been sold, ensuring that the cost of sales accurately reflects the expenses incurred in producing the sold goods.
The specific formula that can be applied is:
COGS = (Beginning Inventory + Purchases) – Ending Inventory
Beginning Inventory refers to the value of goods held by a business at the beginning of an accounting period, while Purchases represent the cost of goods acquired during the same period, inclusive of additional costs like shipping, taxes, and handling charges.
Ending Inventory, on the other hand, denotes the value of goods remaining in stock at the end of the accounting period.
Example:
Let’s consider an example where a business starts the year with an inventory valued at $40,000, ends the year with $16,000 worth of inventory, and makes purchases totalling $18,000 during the year.
By applying the COGS formula:
COGS = ($40,000 + $18,000) – $16,000 COGS = $42,000
In this scenario, the Cost of Goods Sold would amount to $42,000.
How Inventory Costing Methods Impact COGS
COGS is closely tied to the inventory costing method a business employs. The method chosen can significantly influence the calculation of COGS and, consequently, the financial statements of the entity. As per the guidelines of AASB 102, here are the commonly used inventory costing methods:
First-In, First-Out (FIFO):
With FIFO, it’s assumed that the earliest items acquired are the first ones to be sold. This means that the cost of goods sold reflects the cost of the oldest inventory items, while the ending inventory reflects the most recently acquired items.
Last-In, First-Out (LIFO):
Contrary to FIFO, LIFO assumes that the most recently acquired inventory items are the first ones to be sold. Consequently, the cost of goods sold reflects the cost of the latest inventory purchases, and the ending inventory reflects the oldest items.
Average Cost:
This method calculates the average cost of all inventory items available for sale. The average cost is then used to determine the cost of goods sold. It’s a simpler approach compared to FIFO and LIFO, as it averages out the costs of all inventory items regardless of purchase order.
Specific Identification:
This method involves assigning specific costs to individual inventory items sold. It’s commonly used for unique or high-value items, such as artwork or collectibles, where each item’s cost is distinct and identifiable.
The choice of inventory costing method depends on various factors, including the nature of the inventory, its intended use, and industry norms. Each method has its advantages and implications for financial reporting.
Businesses must select the method that aligns best with their inventory management practises and provides the most accurate reflection of their financial performance in their financial statements.
How Understanding COGS Enhances Business Operations
The significance of comprehending Cost of Goods Sold (COGS) cannot be overstated, as it offers a multitude of benefits to businesses
Enhanced Cost Oversight
An awareness of COGS empowers businesses to grasp their costs effectively, enabling informed decisions regarding pricing strategies and inventory management. This, in turn, can bolster profitability by minimising the cost of goods sold and augmenting revenue streams.
Refined Budget Allocation
A thorough understanding of COGS is indispensable for crafting precise budgets. Such insight aids businesses in determining the requisite funds for inventory procurement while pinpointing areas ripe for cost-saving initiatives.
Strategic Future Planning
Familiarity with COGS equips businesses to strategize for future expansion endeavours, be it diversifying product lines, penetrating new markets, or investing in innovative technologies, by assessing feasibility and resource allocation.
Informed Decision Making
Knowledge of COGS is paramount for sound decision-making across various domains such as product development, marketing, and sales. It facilitates the identification of operational enhancements and the identification of cost-efficient pathways to introduce new products to market.
Enhanced Financial Performance
A firm grasp of COGS enables businesses to enhance their overall financial performance by trimming costs and bolstering profitability. This is particularly crucial for enterprises operating on narrow profit margins, as even marginal reductions in COGS can yield substantial improvements in their bottom line.
Limitations
Although, COGS stands as a cornerstone of a business’s financial framework it comes with its share of drawbacks:
- Limited Relevance: COGS solely includes the direct expenses associated with manufacturing and selling a product, disregarding indirect costs like overhead expenses and marketing expenditures. These indirect costs are significant contributors to an entity’s overall profitability but are not factored into the COGS calculation.
- Inventory Valuation Impact: The method employed for inventory valuation can influence the COGS calculation, leading to variations in COGS figures depending on the chosen valuation method. Different valuation methods may yield different costs for inventory, consequently affecting the COGS calculation.
Apart from this, the calculation and reporting of COGS can be influenced by various factors, including changes in accounting policies, estimates, and the correction of errors, as mentioned in AASB 108. The standard provides a comprehensive framework for addressing these aspects, which can significantly impact the reporting of COGS.
COGS in the Financial Statements
In financial reporting, the deduction of the cost of sales from sales revenue determines the gross profit. Gross profit serves as a key indicator of an entity’s profitability This metric is pivotal for stakeholders as it offers insights into the entity’s profitability and operational efficiency.
While entities may adopt various formats for profit or loss reporting, the underlying principle remains consistent: to provide a transparent and precise account of the costs linked with production and sales.
The formula for calculating gross profit is straightforward:
Gross Profit = Revenue – Cost of Goods Sold
For instance, if an entity generates $200,000 in revenue and incurs $150,000 as COGS, the calculation would be:
Gross Profit = $200,000 – $150,000 = $50,000.
This signifies that the entity has a gross profit of $50,000, indicating the revenue remaining after deducting the direct costs associated with production and sales.
This article is general information only and does not provide advice to address your personal circumstances. To make an informed decision you should contact an appropriately qualified professional.