Profit Frog makes understanding the cost of goods sold simple and easy. Our small business forecasting and budgeting software makes the cost of goods sold, operating expenses, and other essential business drivers easy to track and forecast. We make financial planning easy for small and midsize businesses.
What is the Cost of Goods Sold?
Cost of goods sold (COGS), sometimes called cost of sales, measures those costs associated with producing a good or delivering a service, including raw materials and direct labor. For a manufacturing business, any direct manufacturing cost is COGS.
According to generally accepted accounting principles (GAAP), the cost of goods sold is the overall cost of producing the items sold during a selected period of time. Along with revenue, COGS will appear on a company’s income statement.
Our COGS definition: all direct costs involved in manufacturing a product or delivering a service. We like this cost of goods sold definition because it includes service businesses.
How to Calculate the Cost of Goods Sold?
Calculating COGS confuses many entrepreneurs, because the traditional cost of goods sold formula relies on retroactive inventory calculations (we have a better way).
Inventory-based COGS Formula:
COGS = Beginning Inventory + Purchases for the period – Ending Inventory
- Beginning inventory: a business’s inventory at the beginning of an accounting period.
- Purchases: costs incurred to produce a good or service during an accounting period.
- Ending inventory: the inventory remaining at the end of an accounting period.
If a company has a beginning inventory value of $14,000, there are also $5,000 of costs (purchases), and you have $3,000 inventory remaining; that gives a COGS of $16,000 for the accounting period.
With the traditional COGS formula, all inventory that is sold will be shown as sales. The items that didn’t get sold in the previous year become part of the beginning inventory for the upcoming year. If the business makes or purchases additional products, they will be added to inventory.
Cost of Goods Sold Example Using the Inventory Formula
If your business had a beginning inventory of $10,000, and there are also $4,000 of costs (purchases during a specific period of time), you have $2,000 inventory remaining; that gives a COGS of $12,000 for the accounting period.
COGS= $10,000 + $4,000 – $2,000 = $12,000
All inventory that is sold will be shown as sales. The items that didn’t get sold in the previous year become part of the beginning inventory for the upcoming year. If the business makes or purchases additional products, they will be added to inventory.
At the start of each year, any products that got sold in the previous year are removed from the beginning inventory. Once you calculate the total costs of the beginning inventory, as well as all purchases for the period; the resultant number will be subtracted from the sum of beginning inventory and purchases to give your cost of goods sold.
Shortfalls of the Traditional COGS Formula
The traditional cost of goods sold calculation is backwards-looking and is based on inventory valuations. A business compares inventory at the beginning and end of an accounting period. Most often, such inventory costing occurs annually.
Because of the retroactive nature of inventory-based COGS calculations, entrepreneurs are always behind the curve.
For most small businesses, there’s a better way to do COGS accounting.
Profit Frog’s Approach to COGS Calculations
We take a real-time approach to COGS. Business owners plug in all their costs, including COGS, into their dashboard and see a current snapshot of their business’s health.
No waiting until the end of an accounting period: they have up-to-the-moment visibility into the real drivers of their business. Then, they can forecast COGS, OPEX, profit margins, and more into the future by manipulating variables and creating different scenarios. This is known as planning for different scenarios and it helps our customers stay ahead of the curve.
With Profit Frog, business owners don’t need to stress about calculating costs, finding the correct cost of goods sold formula, or trying to calculate OPEX. Just follow our prompts and see how stress-free budgeting and forecasting can be.
Our small business forecasting software is the perfect complement to your existing accounting software.
Profit Frog helps you compute cost of goods sold by having you put in the costs of the following, one by one:
- Direct materials
- Direct labor cost
- Shipping costs
- Other direct costs
A process like this will help you have a clear understanding of what goes into producing every product or service. Ultimately, this will lead to having a better understanding of your business and where your profit centers lie.
How Is COGS Classified In Financial Statements?
On a financial statement, COGS is a business expense because it is one of the costs of generating revenue and doing business.
COGS is the direct cost of producing a good or delivering a service. It includes direct labor costs and materials used. Cost of goods sold is an essential profitability factor; small business owners need to make every effort to reduce cost of goods sold while increasing profit.
Using Profit Frog’s financial modeling software will help you navigate uncertainty and have total visibility into what matters. Profitability modeling will give you the knowledge and power to improve business performance.
Where is COGS on an Income Statement?
Cost of goods sold is usually located directly underneath total revenues when you are looking at an income statement. Gross profit will be listed below, as it is calculated by subtracting COGS from revenue. These figures will give you a clear view of how your business is doing.
Our small business budgeting software will simplify budgeting and help track the cost of goods sold and other expenses easily. Having a clear picture of key business drivers will help you make better strategic decisions and optimize the profitability of your company. We give you a clear view of your company’s expenses and profit centers and show you where you can increase profitability.
Frequently Asked Question About COGS
Are there businesses that don’t have listed COGS?
According to some definitions, certain service-based businesses can’t list COGS on their income statement because they have no inventory. Examples of such businesses would be SaaS companies, accounting firms, and real-estate brokerages.
Another perspective allows that service-based companies can still have COGS (which should probably be re-labeled as cost of services rendered, or COSR, even though we’re still going to use COGS for them). COGS for service businesses would be all the direct costs of delivering the service.
We prefer the latter definition, and help service-based businesses calculate their COGS.
What is COGS in accounting?
Cost of sales, also referred to as cost of goods sold, is an estimate of direct costs incurred in the production of goods sold by a business within a certain time frame. Cost accounting methods will differ depending on the industry, but COGS measures direct costs such as direct labor and materials; it excludes indirect costs like distribution expenses and sales.
For instance, the cost of goods sold by a pastry shop would be the cost of labor used to make the desserts and ingredients. Only costs directly linked to producing pastries are included in cost of goods sold. Costs that aren’t directly involved in the production of goods, such as distribution costs, utilities, and rent, are not included in COGS.
A key part of calculating COGS, traditionally, is inventory. The inventory balance consists of merchandise and products waiting to be sold, cost of raw materials, and work-in-process goods.
The merchandise that didn’t get sold in the previous year becomes the beginning inventory for next year. If the company buys or makes additional products, these will be added to the beginning inventory.
What is OPEX?
Operating expenses, commonly referred to as OPEX and operational costs, are indirect expenses that are crucial to keeping a business running. Operating expenses can range from office supplies to some labor costs to rent and utilities.
Operating expenses are those costs necessary to sustain day-to-day operations, but which are not directly related to delivering a service or producing a good.
The main goal for many companies is to maximize gross sales relative to OPEX. By doing so, OPEX will represent the core measurement of businesses’ efficiency.
The most common examples of operational expenses are:
- Business travel
- Property rates
- Wages and salaries
- Legal fees and accounting
- Interest paid on debt
- Administrative expenses
- Office supplies
- Digital marketing
Is COGS an operating expense?
The difference between cost of goods sold and OPEX is that COGS directly relates to a specific product a business is selling—or a service a company is delivering. OPEX are costs incurred in day-to-day operations, regardless of whether any product is sold or not.
The cost of goods sold is an expense, which means it is not an operating cost.
Operating expenses and costs of goods sold are the cost of doing business and are mutually exclusive. If an expense is COGS it is not OPEX, and vice versa.
What is included in the cost of goods sold?
COGS include all expenses directly tied to producing a product or delivering a service
If a business is selling a physical product, the cost of goods sold will include transportation costs, the value of your inventory, direct material costs, and any other direct expenses.
A business that manufactures or sells products needs to have these fixed and variable costs incorporated:
- Raw materials
- Storage cost
- Transport costs
- Tools and parts used during the production
- Cost of labor (direct)
An indirect cost like payroll or rent are not included in COGS as they are a part of OPEX.
Although accounts receivable and inventory are accounts that an owner will report on the balance sheet, only some expenses on the income statements will involve these items. The cost of goods sold on your income statement will report the small small business inventory cost during an accounting period.
Selling, general, and administrative expenses (SG&A) are included in OPEX. These include most sales force costs, software subscriptions, and other overhead costs.
COGS vs operating expenses calculations are difficult and confusing for an average small business owner. Profit Frog makes calculating operating expenses vs COGS easy and efficient.
Cost accounting and forecasting become easier with Profit Frog.
Limitations of COGS
Inventory-based COGS accounting systems are traditionally used in larger companies. Usually motivated by a desire to impress investors (or potential investors), accountants can manipulate COGS via any of the following:
- Not writing off obsolete inventory
- Fudging the amount of inventory at the end of an accounting period
- Overstating discounts
- Overstating returns to suppliers
- Valuing end-of-period inventory at more than the actual value
Because the value of inventory can be artificially inflated, the cost of goods sold can be under-reported, which can show artificially-inflated net income.
Profit Frog customers typically aren’t subject to the same COGS limitations for the following reasons.
- Our average customer is a bootstrapped Main Street business, not a VC-funded startup
- We don’t use backwards-looking inventory valuation systems for calculating COGS; instead, we use a real-time approach that helps you stay ahead of the curve
What is the Cost Of Goods Sold Percentage?
Cost of goods sold percentage is a financial ratio that compares business expenses generated by sales activity to its revenue. Cost of goods sold percentage is also referred to as:
- Cost of goods sold ratio
- Selling cost to sales ratio
- Cost of sales to revenue ratio
COGS percentage will help you calculate different financial statics and ratios you need to improve profitability. It is the first step to calculating the gross margin ratio. Cost of goods sold percentage is also used when calculating gross markup.
How to calculate gross profit?
Gross profit calculations measure business efficiency. By subtracting the cost of goods sold from revenue, you derive the gross profit number.
How to calculate the gross margin:
Gross Profit Margin = (Revenue – COGS) / Revenue x 100,
Using this formula will show you the percentage of revenues your business keeps after COGS are deducted. This formula indicates how successful your business is at generating revenue while keeping expenses low. You can use a profit modeling tool to make calculations easier…and to ensure accuracy.
By using Profit Frog’s profitability modeling tools, you will simplify budgeting and track your business’s profit. Having a clear picture of what COGS and gross profit are and how they work will reduce any uncertainty and fears.
For example, say a seamstress made a dress for $50. Assuming the average cost for making a dress is $15, the seamstress has a gross profit of $35. In this example, the seamstress would have a gross profit margin of 70%.
With a total cost of $20,000, we can produce 5000 chocolate bars. Therefore, the average cost for the production of 5000 chocolate bars is $15.
- Total product revenue: $50
- Total cost of production: $15
- Gross profit: 50-15 = $35
- Gross profit margin ratio: 35/50 x 100 = 70%
The gross profit margin will vary across sectors and production, but it’s commonly used to measure the profitability of a particular product. It indicates how efficiently you are utilizing the resources in order to manufacture the product or deliver your service.
What is an inventory turnover ratio?
Turnover ratio, also known as inventory turnover, is the rate that products are sold and replaced. The formula for calculating the turnover ratio is:
Inventory turnover ratio = COGS * 2 / (beginning inventory + final inventory).
To calculate your turnover ratio, you’ll need to know the beginning balance and ending balance of inventory, as well as all COGS.
Is COGS an Asset?
Cost of goods sold are not an asset. It is an expense. Expenses are the cost of running a business; they are one of five main accounts in accounting.
Cost of goods sold is an expense account on an income statement, making it a debit. Because COGS is a debit, not an asset, it is a business factor that should be minimized.
Even though accounts receivable and inventory are assets on the balance sheet, only some expenses on the income statements will involve these items. The cost of goods sold on your income statement will report the cost of the inventory your small business sold during an accounting period.
What Are Three Traditional Accounting Methods For COGS
There are three traditional methods for calculating COGS. All are backward-looking and are based on inventory valuations.
For small businesses, we recommend none of these three accounting methods. Instead, we favor a real-time COGS tracking model.
The three traditional COGS accounting methods are the FIFO valuation method, the LIFO method, and the WAC method. All three are formulas to value your inventory—and to derive COGS from inventory values.
What is the profit and loss statement?
Investopedia defines profit and loss (P&L) as “…a financial statement that summarizes the revenues, costs, and expenses incurred during a specified period, usually a fiscal quarter or year.” The definition also continues to say it is synonymous with an income statement.
In short, the profit and loss statement is the best way to get a snapshot of what your business is earning and spending. It’s based on a static time cycle or period and it is used for reporting and looking into the past.
At its basic level, the equation for a P&L statement is Revenue – Expenses = Profit
About Profit Frog
Profit Frog is the leading budgeting and forecasting software specifically designed to eliminate complexity for small businesses. Where other FP&A software solutions focus on complex forecasting of cash flows and other factors suitable to private equity forecasting, Profit Frog strips small business financial modeling down to the thing that matters most: profitability. Our profitability modeling tools allow you to assess the health of your business quickly, and look into the future to understand how all of your variables will affect future profitability as you adjust them. Armed with this knowledge, you can chart a path to maximum profit. Also, for small businesses struggling to grasp the calculation of cost of goods sold, Profit Frog simplifies the process.