Cost of Goods Sold Explained for Dummies

What is cost of good sold (COGS)?

Cost of goods sold (COGS), also known as cost of sales or cost of revenue, refers to all the direct costs associated with the manufacturing of goods or production of products. COGS is typically associated with manufacturing companies, required to determine the cost of inventory items sold during a given financial period.  

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Can businesses have cost of goods sold for services?

Service businesses, such as business consultants, lawyers, and financial service providers, have no inventory to sell. However, they can still have costs that are directly related to the rendering of services, and, therefore, allowed to report these costs on their income statements as cost of goods sold, using an alternative description, cost of services.  

Cost of goods sold (COGS) in the income statement  

It is important to take note of the following aspects regarding the reporting and function of COGS in the income statement of a business:

• COGS is the second line in the income statement, appearing just after sales or revenue.
• To calculate the gross profit of a business, COGS is deducted from sales (revenue).
• The formula for the net profit or net income of a business is: Revenue - Cost of goods sold - Expenses.

 

What type of costs are included and excluded in the cost of goods sold?

The following costs are excluded in the calculation of cost of goods sold:

• Overhead costs, which cannot directly be linked to the production of goods or rendering of services. They are expenses a business incurs, regardless the number of products manufactured. Examples are rent, and utilities such as electricity and water.

 

• Other costs not included in COGS are:
• Advertising and marketing expenses.
• Salaries of administrative personnel and managers.
• Distribution costs such as shipping fees and courier fees.
• Accounting fees.
• Legal fees.
• Interest.
• Capital expenditures.

  The following are examples of costs included in determining the amount for cost of goods sold:

• Direct material expenses.
• Cost of raw materials.
• Cost of products and goods to resell.
• Accessories used in manufacturing of products.
• Container costs.
• Direct labour costs, compensating both full-time and part-time employees who are directly involved in the production of products.
• Indirect labour costs, paying employees who are not directly associated with the manufacturing of goods, but who are involved in the storage and packaging of products.
• Transportation costs for delivery of goods from suppliers.
• Cash discounts.
• Parts used in production.
• Storage costs.
• Factory overheads.

 

How to calculate cost of goods sold (COGS)

Basically, the formula for COGS allows a business to deduct all the costs of the products sold. These are direct costs pertaining to goods manufactured, purchased, or for re-selling. The basic formula for cost of goods sold is: COGS = Beginning inventory + Purchases + Other costs - Closing inventory Where:

• Beginning inventory is the value of inventory at the beginning of a given financial period, which is the closing inventory of the previous financial period.

Put differently, beginning inventory is whatever inventory is remaining after the closing of the previous financial period. Beginning inventory is also called opening inventory.

• Purchases refer to additional items, such as raw materials (in case of manufacturers) and finished products (in case of retailers), acquired during the given financial period.

The following items are also considered with regard to purchases: purchase returns - the items that are returned to the suppliers, purchase allowances - any additional benefits received from suppliers, such as rebates, and purchase discounts - deductions received from suppliers, reducing the costs of purchases.   Purchases also include transportation costs for the delivery of goods from suppliers.

• Other costs comprise all the costs directly associated with the manufacturing of goods by a business. See list above for examples of costs included in cost of goods sold.

• Closing inventory is the value of inventory at the end of a given financial period, becoming the beginning inventory of the following financial period.

  Closing inventory is also referred to as ending inventory.  

More about inventory

Inventory includes a business’s raw materials, work in progress (WIP), merchandise in stock, components of products, and finished products. Inventory is reported on the balance sheet of a business as a current asset at cost. When an item of inventory is sold, the cost of the item is credited in the inventory account (removing the costs from inventory) and recorded as cost of goods sold on the income statement. There are three methods that can be used by a business to remove costs from inventory and report them as cost of goods sold on the income statement. Express differently, the three methods are utilised to record the level of inventory sold during a given financial period. The three methods are:

• First-in-first-out (FIFO)

In this method the finished inventory items that were manufactured first, incurring costs first, are removed first from inventory to cost of goods sold. This process implies that the most recent costs remain in inventory. Put differently, the FIFO-method operates from the understanding that the oldest inventory items are sold first.  

• Last-in-first-out (LIFO)

Contrary to the FIFO-method, the LIFO-method removes the most recent finished inventory items first from inventory and report them as cost of goods sold on the income statement. This means that the inventory items that incurred costs first, stay in inventory. Say in other words, LIFO assumes that the last purchased items are sold first.  

• Weighted average

Frequently, businesses find it difficult to differentiate between older and newer inventory items, because their inventories are stockpiled or combined. Hence, the weighted average-method is used by many businesses, calculating an average per unit cost and applies a cost to both the cost of goods sold and closing inventory.  

Examples of the calculation of cost of goods sold (COGS)

Example #1 The following information for the manufacturing company Good Luck is available:

• Opening inventory: R600 000
• Closing inventory: R850 000
• Purchases: R450 000
• Purchase allowances: R12 000
• Direct costs incurred during the particular financial period:
• Labour: R250 000
• Material: R300 000
• Transportation costs: R90 000
• The company also paid R50 000 to advertise its product.

The cost of goods sold (COGS) of company Good Luck will be calculated as follows: COGS = R600 000 + (R450 000 - R12 000) + R250 000 + R300 000 + R90 000 - R850 000 = R828 000 The advertising costs is not included in the calculation because it is not directly related to the manufacturing of the products.   Example #2 Company Endurance manufactures face masks and buffs. Below are the figures of both the products with regard to the financial year ended 28 February 2026: Face masks

• Opening inventory: 35 000 face masks
• Closing inventory: 15 000 face masks
• Costs pertaining to the manufacturing of the face masks:
• Cost of material: R170 000
• Labour cost: R500 000
• Cost of one face mask: R15
• Freight-in costs: R70 000

Buffs

• Opening inventory: 25 000 buffs
• Closing inventory: 7 000 buffs
• Costs pertaining to the manufacturing of the buffs:
• Cost of material: R150 000
• Labour cost: R470 000
• Cost of one buff: R12
• Freight-in costs: R55 000

  Calculations for cost of goods sold (COGS) for: Face masks Inventory

Inventory	Units	Per unit cost	Total cost
Opening	35 000	R15	R525 000
Closing	15 000	R15	R225 000

  Direct cost   COGS = R525 000 + R740 000 - R225 000 = R1 040 000   Buffs Inventory

Inventory	Units	Per unit cost	Total cost
Opening	25 000	R12	R300 000
Closing	7 000	R12	R84 000

  Direct cost   COGS = R300 000 + R675 000 - R84 000 = R891 000 Total COGS of company Endurance: R1 040 000 (face masks) + R891 000 (buffs) = R1 931 000   Example #3 Company Travel Fast is a courier service company that delivers parcels and documents to customers. Travel Fast incurred the following costs during the past financial year:

• Fuel costs: R15 000
• Cost of labour: R450 000
• Marketing and administrative expenses of R70 000

Calculation of Travel Fast’s cost of goods sold: COGS = R15 000 + R450 000 = R465 000 Take note of the following:

• There is no inventory involved in the calculation of COGS of Travel Fast because it is a purely service company.
• Marketing and administrative expenses are not considered in the COGS calculation because they are indirect costs.

  Example #4 Example #4 will indicate the difference between the 3 methods that can be used to calculate costs to be removed from inventory to a business’s COGS. Assume that company Steadfast purchased materials to manufacture 28 units of their product. The cost per unit for the first 21 units is R20. However, rising material prices increased the cost per unit of the last 7 units to R30 per unit. During the following financial period, the company sold 20 units. First-in-first-out (FIFO) According to the FIFO-method, COGS would comprise the first 20 units manufactured, totalling R400 (R20 x 20). Last-in-first-out (LIFO) Under this method, COGS would consist of the last 20 units manufactured, amounting to R470 ((R30 x 7) + (R20 x 13)). Weighted average  Under weighted average, the calculation will be as follows:

• Determine the unit cost of products available for sale by dividing the total cost of products available for sale by units for sale.

  Thus, the weighted average per unit is: ((R20 x 21) + (R30 x 7))/(21 + 7) = (R420 + R210)/28 = R630/28 =R22.50  

• Multiply the weighted average by the actual number of products sold.

Thus, for the 20 units sold, COGS equals R450 (R22.50 x 20)  

Accounting ratios in which COGS is used

Gross profit margin

The gross profit margin, also called the gross profit margin ratio or gross margin ratio, is a profitability ratio that compares the gross margin of a business to its revenue (sales).   The purpose of the gross profit margin can be expressed as:

• Indicating the percentage of revenue that exceeds COGS.
• Showing how much profit a business makes after paying off all direct costs associated with the manufacturing of goods or the rendering of services.

  The formula to calculate the gross profit margin is: Gross profit margin = (Total revenue (sales) - Cost of goods sold)/Total revenue, illustrated in the following example:   Company Never Give Up reported revenue of R550 000 and COGS of R310 000 for the past financial quarter. The calculation of the gross profit margin of Never Give Up will be as follows:   Gross profit margin = (R550 000 - R310 000)/R550 000 = R240 000/R550 000 =0.44 (expressed as a decimal) To express the GP margin as a percentage, the answer is multiplied by 100 = 44%   The percentage of 44% indicates that for each one South African rand (ZAR) earned as revenue, company Never Give Up retains 44 cents and spends 56 cents to cover its cost of goods sold.  

Cost of goods sold (COGS) to sales ratio

The cost of goods sold (COGS) to sales ratio indicates the percentage of revenue (sales) used to pay for costs that vary directly with the sales of a business.   Formula: COGS to sales ratio = Cost of goods sold/Net sales   Example: Company Try Again has reported, among others, the following figures for the past financial year:

• Sales: R250 000
• COGS: R120 000
• Sales returns: R75 000

Net sales = R250 000 - R75 000 = R175 000 Cost of goods sold (COGS) to sales ratio = R120 000/R175 000 = 0.69 (expressed as a decimal), or 69% (expressed as a percentage) The lesser the ratio, the more effective a business generates revenue at a low cost.  

Inventory turnover ratio

The inventory turnover ratio, commonly called inventory turnover, is a financial ratio indicating the number of times a business has sold and replaced its inventory during a specific financial period. There are two methods to calculate inventory turnover:

• the one using the cost of goods sold, and
• the one using sales.

Usually, analysts prefer the method using COGS for greater accuracy because sales include a markup over cost. Formula: Inventory turnover ratio = Cost of goods sold/Average inventory Where: Average inventory = (Beginning inventory + Closing inventory)/2 Example: The manufacturing company Happy Days has COGS of R1 000 000 for the past financial year. Its closing inventory was R150 000 and beginning inventory at the start of the year was R200 000. Calculation of the inventory turnover ratio of Happy Days looks as follows: R1 000 000/((R200 000 + R150 000)/2)) = R1 000 000/R175 000 = 5.7 times a year Generally, a high inventory turnover is an indication that goods are sold faster. Conversely, a low turnover rate means poor sales and excess inventories.  

Why is cost of goods sold important?

There are numerous reasons why the calculating and understanding of COGS are important. Here are some of them:

• Financial ratios that include COGS are used as metrics to determine how efficiently a business manages its inventory and costs directly related to the manufacturing of goods and providing of services. (See ‘Accounting ratios in which COGS is used’ above.)
• The gross profit margin, comprising revenue (sales) and GOGS enables a business to determine how much money it has left after taking COGS into consideration.
• COGS helps a business to differentiate between direct and indirect costs. Calculating its indirect costs, will call attention to the business’s break-even point, the amount of money required to pay monthly costs, regardless the amount of revenue generated.
• COGS calculated accurately, enables a business manager to determine the real costs of the products sold or services provided. This is essential when the prices of products and services are set.

  Product pricing is one of the crucial and important responsibilities of a business manager. On the one hand products prices are needed to be just right in order to make them attractive for customers, but on the other hand to allow a business to generate a healthy profit.   Simply put, too high prices might discourage customers to buy the products. Conversely, prices too low can jeopardise a business’s changes to break-even.   In addition, COGS helps a business to determine when prices on a particular product or service need to increase.  

• COGS can help a business to determine how effectively it manufactures what it sells. Does COGS increase or decrease in line with how much of a product is sold? For example, if costs are increasing but sales are not increasing, that might be a warning sign of something to be investigated.

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