Cost of goods sold (COGS) measures the cost of the goods a business sells during an accounting period. Tracking it helps businesses understand gross profit, review pricing and identify changes in purchasing or production costs.
This guide explains what COGS includes, how to calculate it with an example, and how inventory costing methods affect the result. It also covers differences across industries and why accurate records matter.
What is the cost of goods sold (COGS)?
Cost of goods sold is the cost assigned to goods sold during an accounting period. It includes the cost of purchased goods or, for manufacturers, materials, direct labour and allocated production overhead. Costs relating to unsold goods remain in inventory until those goods are sold.
Subtracting COGS from net sales gives gross profit. Comparing COGS with sales helps businesses assess product profitability and review purchasing, production and pricing decisions.
Gross profit = Net sales − COGS
Components of COGS
For manufacturers, inventory costs include direct materials, direct labour and allocated manufacturing overhead. These costs become part of COGS when the related goods are sold.
Direct materials
Direct materials are the raw materials and components used to make a product. Examples include:
- Wood and fittings used in furniture
- Flour and butter used in bakery products
- Circuit boards and screens used in electronics
Changes in material prices or usage affect production costs.
Direct labour
Direct labour includes wages and related employment costs for workers directly involved in production. Examples include:
- Assembly workers producing vehicles
- Tailors making garments
- Bakers preparing bread
Labour rates and production time influence the cost of each unit.
Manufacturing overhead
Manufacturing overhead covers indirect production costs allocated to inventory. Examples include:
- Factory rent and maintenance
- Depreciation of production equipment
- Factory electricity and indirect materials
- Production supervision costs
Overhead includes both fixed and variable costs. Fixed production overhead is generally allocated using normal production capacity, while variable overhead reflects actual production activity.
How to calculate COGS for small businesses?
For a business that buys finished goods for resale, the basic formula is:
COGS = Beginning inventory + Net purchases − Ending inventory
- Beginning inventory: The cost of goods held at the start of the accounting period, carried forward from the previous period’s closing inventory.
- Net purchases: Inventory purchases after returns and discounts, including directly attributable acquisition costs such as freight inward.
- Ending inventory: The value of unsold goods held at the end of the period.
Use inventory values at cost, rather than selling prices. Manufacturing businesses also need to account for production costs and changes in raw materials, work in progress and finished goods.
Example
A retailer has the following inventory figures for the month. Assume net purchases include the relevant acquisition costs and there are no other inventory adjustments.
| Particulars | Amount |
|---|---|
| Beginning inventory | ₹2,50,64,900 |
| Net purchases during the month | ₹5,37,10,500 |
| Ending inventory | ₹89,50,187 |
Let's apply it to an example. Say you are a car manufacturer and had a beginning inventory of INR 2,50,64,900 last month and purchased another INR
COGS = ₹2,50,64,900 + ₹5,37,10,500 − ₹89,50,187
COGS = ₹6,98,25,213
The retailer can subtract this amount from net sales to calculate gross profit. Reviewing the figures by product category can also help identify changes in costs and margins.
g margin for each product, so you can analyse which products you are paying too much for and which products is enabling him to make the most money.
Impact of inventory accounting methods on COGS
Inventory costing methods determine which costs are assigned to goods sold and which remain in closing inventory. They describe the flow of costs, which may differ from the physical movement of goods.
First In, First Out (FIFO)
FIFO assigns the earliest inventory costs to goods sold first. When purchase costs rise, it generally produces lower COGS and higher gross profit than weighted average costing, with other factors unchanged.
Last In, First Out (LIFO)
LIFO assigns the latest inventory costs to goods sold first. During rising prices, it generally produces higher COGS than FIFO. However, LIFO is not permitted under AS 2 or Ind AS 2, so it should not be presented as an available financial-reporting choice for businesses following those standards.
Weighted Average Cost
This method calculates an average unit cost using the total cost and quantity of comparable goods available. That cost is used to value goods sold and remaining inventory, reducing the effect of individual purchase-price changes.
Specific Identification
Specific identification assigns the actual cost of an individually identifiable item to COGS when it is sold. It is suitable for inventory that is not ordinarily interchangeable, such as individually identifiable custom machinery.
COGS in different industries
Manufacturing Businesses
Manufacturers include materials, direct labour and allocated production overhead in the cost of goods sold. For example, a car manufacturer includes steel, assembly labour and allocated machinery depreciation relating to vehicles sold.
Retail Businesses
Retailers include the acquisition cost of goods sold, including relevant freight inward and after purchase discounts or returns. For example, a clothing retailer tracks the cost of the garments it sells.
Service Businesses
Businesses that provide services without selling goods generally track direct delivery costs as cost of services rather than COGS. A consulting firm, for example, may track consultants’ delivery time as a service cost, while a repair business may also have COGS for spare parts sold.
Importance of accurate COGS calculation
- Profit calculation: Accurate COGS helps businesses calculate gross profit correctly and identify changes in margins.
- Business decisions: Cost analysis supports pricing, supplier negotiations, production planning and budgeting.
- Inventory management: Used alongside inventory balances and sales data, COGS helps assess inventory turnover and purchasing needs.
- Industry benchmarking: Comparing COGS as a percentage of sales can help assess performance, provided the businesses use comparable cost classifications and accounting methods.
Errors in COGS can distort reported profit and lead to poor decisions. Reconcile inventory records and review cost classifications regularly.
Conclusion
Accurate COGS calculation helps businesses understand gross profit, review pricing and monitor purchasing or production costs. The calculation depends on including the right costs and applying an appropriate inventory costing method consistently.
Reliable inventory tracking supports this process. Keep purchase, production and stock records up to date, reconcile physical stock with recorded balances, and investigate differences before using the figures for business decisions.
