What is cost of goods sold (COGS) and why is it important?

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Running a business involves a lot of hidden costs. These can be anything from equipment and maintenance upgrades, employee turnover, credit card fees, interest on loans, permits and licences, and more. Understanding these costs is key to ensuring that your business is successful and meeting its financial goals.

As a small business, it’s incredibly important to stay on top of your finances post-launch. After all, almost three in five SMEs in the UK fail due to cash flow problems

And as you scale, having a clear overview of how your operations, revenue and profits go hand in hand is paramount for your company’s bottom line performance.

Cost of goods sold, or COGS, therefore, is an important metric to help you gain a full overview of your company’s finances.  

In this article, we’ll help you understand what COGS is, how to calculate it, and why it matters for your business.

Quick Tip: Before diving into the specifics of COGS, it’s important that you have a general understanding of small business accounting as a whole. This includes how to open a business current account, how to track your expenses, the pros and cons of hiring an accountant or bookkeeper, how to calculate your business tax, and so much more. To gain a high-level overview, we recommend reading our beginner’s guide to small business accounting.

Table of contents

  1. What is cost of goods sold (COGS)?
  2. How to calculate COGS
  3. Examples of COGS
  4. What is excluded from COGS?
  5. Interpreting COGS for your business
  6. Why it’s important to know your COGS
  7. Problems with COGS
  8. Wrapping up

What is cost of goods sold (COGS)?

Cost of goods sold is the total cost incurred by a business in the production of goods or services. It is also referred to as the cost of sales or cost of services.

A business typically incurs two types of costs: direct and indirect.

Direct costs are costs that can be traced back to a specific product, service, or activity. These include the direct costs of materials, labour, commissions and more.

Indirect costs, however, are costs that are crucial to the production process but are difficult to be traced back to any specific object of production. These include overhead costs like utilities, cleaning and office supplies, rent and so on.

When calculating COGS, you only need to take the direct costs of production into account.

As an example, consider a company that sources raw materials from an external supplier. In this case, COGS will include the cost of conversion—the production cost necessary to convert raw materials into finished goods—and other costs involved in bringing the stock to their present location and condition.

If we take the example of a services business, COGS will include direct labour costs, payroll taxes, and benefits of workers who generate billable hours. We will discuss this in further detail below.

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How to calculate COGS

Cost of goods sold is calculated by first adding the cost of purchased or manufactured inventory to the cost of beginning inventory for the specified period, and then subtracting the cost of ending inventory from the total.

Here’s the formula for calculating COGS:

Infographic that illustrates how to calculate COGS

Cost of Goods Sold = Beginning Inventory + Additional Inventory – Ending Inventory

  • Beginning inventory: This is the cost of inventory that’s on-hand at the beginning of a specified period. The beginning inventory includes the products and raw materials that were not sold in the previous period.
  • Additional inventory: This is the cost of additional inventory that was purchased during the specified period. This includes the costs of direct labour, direct materials, and direct overheads, such as warehouse expenses, rent, and electricity directly tied to the production of the goods or services in question.
  • Ending inventory: This is the cost of inventory that the company has at the end of the specified period. The ending inventory includes the products and raw materials that weren’t sold during the period.

Additionally, you need to know what inventory cost method your business or accountant is using before you can start calculating your COGS.

The inventory cost method is the way your business manages costs and it directly impacts the value of the cost of goods sold.

There are three inventory cost methods used by businesses:

  • LIFO
  • FIFO
  • Average cost method

FIFO

FIFO stands for First In, First Out.

In this inventory cost method, the earliest manufactured or purchased goods are sold first.

In a period of inflation where the prices to purchase inventory increase over time, you will be selling your least expensive inventories first using the FIFO method.

For example, say your business sells fabric and you spent £2 for 100 pieces on Monday. By Wednesday, inventory is running low so you make another order for 100 pieces. However, On Wednesday, the price is £2.50.

Because you bought the £2.00 items first, you will sell the cheaper items first—first in, first out. 

This means that the value of COGS using FIFO will be relatively lower than with using any other method because you are buying and selling your cheaper inventory first.

LIFO

LIFO stands for Last In, First Out.

This type of inventory costing is the complete opposite of FIFO. In this method, the most recently manufactured or purchased goods are sold first.

In the same scenario as above regarding price inflation, you will be selling your most expensive items first using the LIFO method.

So, using the fabric example, this time, you will be selling the inflated items first—last in, first out.

This means that the value of COGS using LIFO will be relatively higher than with using the FIFO method.

Average cost method

To avoid drastic changes in the value of COGS, companies often use the average cost method to manage their inventory costs.

In this method, the average cost of all purchased or manufactured inventory is used, regardless of their purchase or production date. This prevents inaccurate or extreme values and makes it easier to calculate COGS, profitability, and taxes.

Infographic demonstrating the differences between FIFO and LIFO

Examples of COGS

To help you better understand how to calculate COGS for your business, take a look at the detailed examples of fictional businesses below.

Caravan T-Shirts (No inventory inflation)

Caravan is a T-shirt company that just started operating. They bought 500 T-shirts from a wholesaler for £5 each at the beginning of the year. During the year, the business successfully sold 350 T-shirts to its customers at the price of £8 each. 

First, we’ll calculate the beginning, additional, and ending inventory for Caravan T-shirts:

  • The beginning inventory is 0, because the business just started its operation. 
  • The additional inventory is calculated as 500 x £5 = £2500.
  • The ending inventory is calculated by multiplying the number of T-shirts left by the end of the year with the cost of each T-shirt: (500-350) x £5 = £750.

Next, we’ll plug in the three values into the formula to find COGS:

Cost of Goods Sold = Beginning Inventory + Additional Inventory – Ending Inventory

COGS = 0 + £2500 – £750

COGS = £1750

Caravan T-Shirts (Including inventory inflation)

Now, let’s dive in deeper to calculate COGS based on the three methods we learned above. 

Let’s say instead of buying 500 T-shirts at the beginning of the year, they bought 250 for £5 apiece. The next month they bought an additional 250 for £7 apiece. They sold their T-shirts for £8 each and at the end of the year, they had successfully sold 225 T-shirts, leaving 275 unsold. 

Month Units Purchased Cost per Shirt  Value
January 250 £5 £1250
February 250 £7 £1750
500 total purchased

We can’t simply run these numbers through the COGS formula, as the inventory has two different values. Therefore, let’s see what the ending inventory equals using the three inventory costs methods. 

FIFO

FIFO means that you sell the items you purchased first to your customers. In our example, this means the 250 units purchased in January for £5 each. 

So, the ending inventory calculation, in this case, will be:

225 x £5 = £1,125

LIFO

LIFO means that you sell the items that you purchased most recently. In our example, this means the 250 units purchased in February for £7 each.

The ending inventory calculation, in this case, will be:

225 x £7 = £1,575

Average cost method

Average cost takes into account the average inventory cost during a specific period. In our example, the average of January and February comes out to be (£5 + £7)/2 = £6.

The ending inventory calculation, in this case, will be:

225 x £6 = £1,350

Now, we can calculate our COGS based on the inventory cost method that our business subscribes to. For our example, let’s say we use the average cost method. This means our ending inventory cost would be £6.

Knowing this, we can complete our calculation:

  • The beginning inventory is 0, because the business just started its operation. 
  • The additional inventory is calculated as 500 x £6 = £3000.
  • The ending inventory is calculated by multiplying the number of T-shirts left by the end of the year with the cost of each T-shirt: (500-275) x £6 = £1350.

Next, we’ll plug in the three values into the formula to find COGS:

Cost of Goods Sold = Beginning Inventory + Additional Inventory – Ending Inventory

COGS = 0 + £3000 – £1350

COGS = £1650

Smack-it Sports (No inventory inflation)

Smack-it Sports has been manufacturing hockey sticks for many years. At the beginning of the year, they had £10,000 worth of hockey sticks on-hand. During the year, they bought 5000 hockey sticks for £25 each, and by the end of the year, they had 320 hockey sticks left on-hand.

  • The beginning inventory is £10,000.
  • The additional inventory is 5000 x 25 = £125,000.
  • The ending inventory is 320 x 25 = £8,000.

To calculate COGS for Smack-it Sports, we’ll simply plug in the values in the formula:

Cost of Goods Sold = Beginning Inventory + Additional Inventory – Ending Inventory

COGS = £10,000 + £125,000 – £8,000

COGS = £127,000

Smack-it Sports (Including inventory inflation)

Now, let’s dive in deeper to calculate COGS based on the three inventory cost methods we learned above. 

Let’s say Smack-it Sports had no beginning inventory. They bought 3,000 hockey sticks in January for £20 apiece and 2,000 hockey sticks in February for £25 apiece. At the end of the year, they had successfully sold 2,500 hockey sticks at a selling price of £50 each.

Month Units Purchased Cost per Hockey Stick Value
January 3,000 £20 £60,000
February 2,000 £25 £50,000
5,000 total purchased

FIFO

FIFO means that you first sell items you purchased the earliest to your customers. In our example, this means the 2,500 units purchased in January for £20 each. 

So, the ending inventory calculation will be:

2500 x £20 = £50,000

LIFO

LIFO means that you first sell items that you purchased most recently. In our example, this means we’ll first sell the 2,000 recently purchased hockey sticks, and then sell the remaining 500 hockey sticks from the older inventory.

The ending inventory calculation will be:

(2000 x £25) + (500 x £20) = £60,000

Average cost method

Average cost takes into account the average of the costs. In our example, the average of January and February comes out to be £22,5 [(20+25)/2].

The ending inventory calculation will be:

2500 x £22.5 = £56,250

In this example, let’s assume our inventory cost method is FIFO. This means our ending inventory would amount to £50,000.

Knowing this, we can complete our calculation:

  • The beginning inventory is 0, because the business just started its operation. 
  • The additional inventory is calculated as 5000 x 20 = £100,000
  • The ending inventory is calculated by multiplying the number of hockey sticks left by the end of the year with the cost of each stick: (5000-2500) x £20 = £50,000.

Next, we’ll plug in the three values into the formula to find COGS:

Cost of Goods Sold = Beginning Inventory + Additional Inventory – Ending Inventory

COGS = 0 + £100,000 – £50,000

COGS = £50,000

What is excluded from COGS?

According to the Generally Accepted Accounting Principles (GAAP), COGS is defined as the cost of inventory that’s sold during any given period.

But what about companies that don’t have any inventory at all? These could include:

  • SaaS businesses
  • Business consultants
  • Professional dancers
  • Accounting firms

Since these companies have zero COGS, there are no COGS listed in their income statement.

But that doesn’t mean they don’t have any expenses. Such companies may still be subjected to operating expenditure, such as rent, utilities, and office supplies.

Quick Tip: If you are operating a business that doesn’t have any inventory, you’ll still face many expenses and costs, especially pre-launch. It’s important to understand the difference between one-time, fixed, essential and optional costs. The more you understand how much money you’ll need to cover all of your operating expenses, the better prepared you’ll be to maintain a healthy cash flow post-launch. To learn more, read our guide on how much it costs to start a business in the UK.

Interpreting COGS for your business

There are several different things that COGS can tell you about your business.

First of all, COGS can help you measure your business’s operational efficiency by helping you find out what part of production is increasing your costs.

You can minimize the costs incurred in production by either employing better operational tactics or minimizing wastage and spillage in the production process.

Here are some other things you can do to be more operationally efficient:

  • Avoid damages and/or thefts the best you can
  • Stop overstocking—the last thing you want is to have too much inventory on-hand, as it also drives up storage and warehousing costs
  • Ensure that you never run out of stock—the lack of inventory can make you lose revenue, and last minute orders are likely to be more expensive

COGS can also be used by businesses to compare the costs of different products.

If your company manufactures several products, it’s helpful to know which products cost you more to produce. You can also compare the processes used to produce different products to identify where you could possibly be wasting money.

If your business is operating efficiently, but your COGS is still too high, you might want to reconsider whether to continue or discontinue selling a product.

Additionally, COGS can be used in various metrics and ratios to help you keep track of the financial health of your business. Here are a few ratios where COGS is used:

1. Gross margin 

Gross margin is the percentage of sales revenue a company retains after incurring all COGS.

To calculate the gross margin for your business, use this formula:

Gross margin = (Sales Revenue – COGS) / Sales Revenue x 100

The higher the gross margin, the more the business retains from each dollar of revenue.

Example

For the year 2019, Company X reported a total revenue of £800,000 and cost of goods sold of £400,000. Let’s use the formula above to find out their gross margin:

Gross margin = (£800,000 – £400,000) / £800,000 x 100

Gross margin = 50%

This means that Company X retained 50% of its total revenue for the year after deducting all the costs associated with producing the goods sold.

2. COGS ratio

This ratio shows the percentage of sales revenue used by a business to pay for expenses that vary directly with sales.

To calculate the COGS ratio for your business, use this formula:

COGS ratio = COGS / Net Sales x 100

A low COGS ratio means that the costs incurred in production are lower in comparison to the generated sales.

Example

Company X reported total net sales of £700,000 and cost of goods sold of £500,000 for the year. Let’s use the formula above to find out their COGS ratio:

COGS ratio = (£500,000 / £700,000) x 100

COGS ratio = 71.4%

This means that Company X spent 71.4% of its total sales revenue on expenses related to the production of goods sold during the year. This is a high COGS ratio and the company should probably consider reducing their production costs.

3. Inventory turnover

This is an important ratio used to measure how well a company generates sales from its inventory. It shows how many times a company has sold and replaced inventory during a given period.

To calculate the inventory turnover for your business, use this formula:

Inventory turnover = COGS / Average Inventory

The average inventory can be found by adding the beginning and ending inventory and then dividing the total by two.

A low inventory turnover indicates weak sales and excessive inventory.

Example

In the beginning of the year, Company X had £350,000 worth of inventory. During the year, they bought £500,000 worth of additional inventory. At the end of the year, they had £250,000 worth of inventory left.

Let’s find out the inventory turnover for Company X:

The first step is to calculate COGS.

COGS = Beginning inventory + Additional inventory – Ending inventory

COGS = £350,000 + £500,000 – £250,000

COGS = £600,000

Inventory turnover = COGS / Average inventory

Inventory turnover  = £600,000 / (£350,000 + £250,000 / 2)

Inventory turnover = 2

Quick Tip: There are tons of other accounting formulas that you can use to manage cash flow and business operations. Regardless of whether you employ an accountant or bookkeeper, understanding the basics of these accounting methods will help you to achieve and maintain profitability. To learn about the various accounting methods, financial statements and fundamental accounting tasks, read our complete guide to accounting for startups.

Why it’s important to know your COGS

Calculating COGS has several benefits for your small business.

1. Setting the right price for your products

If you know your COGS, you can set the right price for your product.

A good product price allows you to cover your costs while leaving you a healthy profit margin. Knowing your COGS can help you determine exactly when you need to increase or decrease your prices.

Quick Tip: Beyond COGS, you have to consider your target market and audience when coming up with a price point. Do you want to price your products at a higher, lower or similar price point to your competitor’s? There’s a lot to consider and it’s crucial to do thorough market research to learn everything you can about your target market. Once complete, dive into our guide that explores 6 steps on how to price a product and achieve profitable markups.

2. Understanding the financial health of your business

By finding out the cost of your production processes and using COGS to calculate different ratios, you can better understand the overall financial health of your company.

This helps you make decisions like whether you need to invest more in your operations or improve the way you manage your inventory.

It also helps you figure out whether you can afford to pay back your debts, if you should cut down on payroll costs, or if you should completely shut down your business operations.

3. Effectively managing your taxes

Cost of goods sold is a business expense, which means it’s tax-deductible.

Knowing your COGS can help you effectively manage your taxes and avoid getting into legal trouble.

If your COGS is high, you’ll pay lower taxes because you’ll have less net income. But, although paying less taxes can effectively save your business money,high COGS can also mean that your business is not making enough profit. You need to find a healthy balance to ensure efficiency and profitability for your business.

4. Identifying future opportunities for growth

Historical changes in COGS can help your business find seasonal trends in the costs of raw materials. In order to figure out these historical changes, analyse your COGS over the past few years, for example, to decipher seasonality variations. You may notice that your COGS are consistently higher in the winter months. If so, this information can be used by businesses to identify areas of growth and improvements.

Quick Tip: Another way to efficiently identify growth opportunities is by creating a cash flow forecast. This process can help you make better strategic business decisions by estimating sales, income and general business expenses over a 12 month period. To learn more, read our article that explains what a cash flow forecast is and how to create one.

Problems with COGS

COGS can, unfortunately, be altered or manipulated to show a favourable or unfavourable situation of a business. This is generally done to help a business achieve its goals on paper, even if that’s not entirely the case in reality.

COGS can also be over-reported to avoid paying taxes to the government. Conversely, they can be under-reported to make the company look like more of an attractive prospect to investors.

Here’s how COGS can be altered:

  • Allocating higher overhead costs to inventory than actually incurred
  • Overvaluing returns to suppliers
  • Overvaluing inventory on hand
  • Overvaluing discounts
  • Forging the amount of ending inventory

COGS aren’t manipulated often, but it’s important to understand that they can be to make sure it never happens under your watch.

Wrapping up

For a small business, effectively managing costs and operations is key to higher profits and, ultimately, survival.

Keeping track of your COGS will help you better understand which areas of production are eating up most of your money and where you can increase efficiency. 

However, if you find that your COGs are high even if your business is operating efficiently, that presents an opportunity to reevaluate the products you’re selling. You don’t want to overstock unpopular items or, conversely, sell popular items at a price point that is lower than the production cost. 

Tracking your COGS will help you make smarter business decisions and help you improve the overall financial health of your business.

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Photo by Andrea Piacquadio, published on Pexels

Valentine Hutchings

Head of Community and small business enthusiast

Tide Team

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