COGS (Cost of Goods Sold) 

 

COGS (Cost of Goods Sold)  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 important for businesses as it aids in determining the profit margin, which serves as an indicator of financial performance. 

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?  

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. 

Business accountant or banker, businessman calculate and analysis with stock financial.

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.

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.