Cost of Goods Sold (COGS): Meaning, Formula, and Calculation Guide

Tallysolutions

Tally Solutions

April 15, 2025

Understanding the Cost of Goods Sold (COGS) is fundamental for any business that deals with inventory, whether in manufacturing, retail, or service industries with tangible components. COGS represents the direct costs incurred in producing goods or purchasing inventory that a company sells during a specific period. This financial metric plays a significant role in determining a business's gross profit, pricing strategy, and overall profitability.
For business owners, investors, and accountants, an accurate COGS calculation is essential to analyse financial performance, optimize expenses, and check for compliance with tax regulations. By properly tracking COGS, businesses can ensure they are pricing their products competitively while maintaining a healthy profit margin.
This blog will delve into the definition of COGS, its components, exclusions, and how to calculate it accurately. It will also explore the impact of different inventory accounting methods on COGS, how it varies across industries, and common mistakes to avoid when calculating it. Whether you're a small business owner, an accountant, or a financial analyst, this guide will help you gain in-depth knowledge of COGS and its significance in business decision-making. Let's get started!

What is the cost of goods sold (COGS)?

The cost of goods sold (COGS) is any direct cost related to the production of goods that are sold or the cost of inventory you acquire to sell to consumers. It does not include overhead expenses related to the general operation of the business, such as rent. Cost of goods sold is reported on a company's income statement.

COGS are a part of the income statement where costs directly related to either the product or goods sold by a company, or the costs of acquiring inventory to sell to consumers. If the cost of goods sold exceeds the revenue generated by the company during the reporting period, means that there has been no profit. The formula to calculate cost of goods sold is extremely crucial to the management as it helps analyse how well purchasing and payroll costs are being controlled.

Creditors and investors also use cost of goods sold to calculate the gross margin of the business and analyse what percentage of revenues is available to cover operating expenses. Both manufacturers and retailers list cost of goods sold on the income statement as an expense directly after the total revenues for the period. COGS is then subtracted from the total revenue to arrive at the gross margin.

Components of COGS

COGS consists of all direct costs incurred in the production or purchase of goods that a business sells. These costs can be classified into the following categories:
1. Direct materials
These are raw materials and supplies directly used in the production of goods. Some of the examples include:
A furniture manufacturer includes wood, nails, and varnish
A bakery includes flour, sugar, and butter
An electronics company includes circuit boards, wires, and screens
Without these materials, production cannot occur. Any fluctuation in material costs affects COGS directly.
2. Direct labour
It refers to the wages paid to employees directly involved in manufacturing goods. Such staff are:
Factory workers assembling cars
Tailor sewing garments
Bakers preparing dough and baking bread
Labour costs vary based on productivity, wages, and efficiency. Companies need to optimise labour usage to control COGS.
3. Manufacturing overhead
It is defined as indirect costs that support production but are not directly traceable to a single unit. Some examples include:
Factory rent and maintenance
Depreciation of manufacturing equipment
Utilities like electricity and water in the factory
Insurance and property taxes for manufacturing facilities
These costs are necessary for production but do not change with the number of units produced.

How to calculate COGS for small businesses?

The cost of goods sold formula is calculated by adding purchases for the period to the beginning inventory and subtracting the ending inventory for the period.

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

The beginning inventory for the current period is calculated as per the leftover inventory from the previous year. Any additional inventory which has been purchased or produced is added to the beginning inventory. To arrive at the Cost of Goods Sold, products that were not sold are subtracted from the sum of beginning inventory and additional purchases.

Example

Cost of goods sold (COGS) is the cost of acquiring or manufacturing the products that a company sells during a period, so the only costs included in the measure are those that are directly tied to the production of the products, including the cost of labour, materials, and manufacturing overhead. For example, the COGS for an automaker would include the material costs for the parts that go into making the car plus the labour costs used to put the car together. The cost of sending the cars to dealerships and the cost of the labour used to sell the car would be excluded.

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 5,37,10,500 in inventory. Last month was a good month, and your remaining inventory at the end of the month was INR 89,50,187. Try and calculate COGS by yourself before you scroll down to see the answer.

Okay, now let's apply the formula.

COGS = 2,50,64,900 + 5,37,10,500 - 89,50,187

Therefore, COGS = INR 6,98,25,213

This information will not only help you plan out purchasing for the next year, it will also help you evaluate the costs. For instance, you can list the costs for each of your product categories and compare them with the sales. This comparison will give you the selling 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

The value of the cost of goods sold depends on the inventory costing method adopted by a company. There are three methods that a company can use when recording the level of inventory sold during a period: First In, First Out (FIFO), Last In, First Out (LIFO), and the Average Cost Method.

FIFO

The earliest goods to be purchased or manufactured are sold first. Since prices tend to go up over time, a company that uses the FIFO method will sell its least expensive products first, which translates to a lower COGS than the COGS recorded under LIFO. Hence, the net income using the FIFO method increases over time.

LIFO

The latest goods added to the inventory are sold first. During periods of rising prices, goods with higher costs are sold first, leading to a higher COGS amount. Over time, the net income tends to decrease.

Average Cost Method

In this methd to calculate COGS, it is assumed that the inventory cost is based on the average cost of the goods available for sale during the period. The average cost is computed by dividing the total cost of goods available for sale by the total units available for sale. This gives a weighted-average unit cost that is applied to the units in the ending inventory.

Special Identification Method

This method uses the specific cost of each unit of the inventory or the goods, to derive at the ending inventory and COGS for each period. With the help of this method, a business owner or the accountant can identify which item was sold at what cost. 

COGS in different industries

COGS calculation varies depending on the industry. Here’s how it applies across different business types:
1. Manufacturing business
Here, COGS includes raw materials, direct labour, and factory overhead. An automobile manufacturing unit is a good example, as it includes the cost of steel, wages for assembly workers, and machinery depreciation.
2. Retail business
In a retail operation, COGS includes the purchase price of goods sold. For example, a clothing store calculates COGS based on the wholesale price paid for each garment.
3. Service-based business
In a service-oriented business unit, COGS is often minimal but may include direct labour costs. For instance, unlike other companies, a consulting firm includes the salaries of consultants directly involved in providing services.
Understanding these variations helps businesses track costs and profits accurately.

Importance of accurate COGS calculation

Accurate COGS calculation is essential for several reasons:
Profit calculation: COGS need to be deducted from revenue to determine the accurate gross profit. It helps assess how efficiently a company is producing and delivering its goods.
Informed business decisions: Investors and stakeholders often look at COGS to assess operational efficiency. As it supports financial planning, budgeting and forecasting.
Inventory management: COGS provides insights into inventory turnover and product demand, which helps businesses avoid overstocking or understocking.
Industry benchmarking: COGS allows comparison of production efficiency with industry standards or competitors. Useful for identifying whether you're overpaying or outperforming.

Businesses that miscalculate COGS may end up reporting incorrect profits, leading to poor financial decisions or compliance issues.

Conclusion

Cost of Goods Sold (COGS) is a fundamental financial metric that helps businesses track their production expenses and profitability. Understanding its components, exclusions, and calculation methods ensures accurate financial reporting and informed decision-making for stakeholders.
By implementing proper inventory valuation methods and avoiding common mistakes, businesses can optimise their cost management, pricing strategies, and overall financial health.
For businesses using Tally Solutions products, COGS calculations and inventory management can be streamlined with automated tracking and reporting, ensuring accurate financial data for better business decisions.

FAQs

  • How do you calculate cost of goods sold (COGS)?

To find the cost of goods sold during an accounting period, use the COGS formula:

COGS = Beginning Inventory + Purchases During the Period – Ending Inventory

Your beginning inventory is whatever inventory is left over from the previous period. Then, add the cost of what you purchased during the period. Subtract whatever inventory you did not sell at the end of the period.

  • Are salaries included in COGS?

No. Salaries and other general and administrative expenses are not included in COGS. But, certain types of labor costs can be included in COGS, provided that they are directly associated with specific sales.

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