Cost of Goods Sold (COGS), otherwise known as cost of sales, is a tool that can help you understand the total cost of materials and manufacturing needed to create retail products.
Learn more about how better understanding your inventory costs can help your business in the Future of Reverse Logistics
In this blog, we will cover the following:
- What COGS means
- How calculating COGS can help your company’s profit margin
- The formula and accounting methods used to understand COGS
- How focusing on returns and generating revenue during this process can lower COGS
COGS is the total amount of money it takes to produce the goods your company sells that you report on financial statements. It includes both direct and indirect costs.
Direct costs cover things like raw materials needed to create the product, supplies needed for production, the cost of packaging and any overhead costs. Direct costs also includes labor costs, such as wages paid to employees who work on manufacturing the product. Indirect costs cover equipment, manufacturing parts, and shipping rates.
COGS is different from Selling, General and Administrative (SG&A), which covers marketing and administrative expenses. COGS is also separate from Operating Expenses (OPEX), which include expenses such as rent, utilities, office supplies, legal costs, sales and marketing, payroll, and insurance costs.
Understanding COGS is key to helping your company grow and can impact your accounting and sales. A higher COGS means a lower profit margin. It’s also considered a cost of doing business and can appear as a business expense on income statements. Learning how to lower COGS will help analysts, investors, and managers estimate a business’s bottom line while increasing gross profit.
The COGS formula
In order to calculate COGS, you’ll need to utilize specific accounting methods. One is the valuation method, meaning your business’s current and future profitability and potential growth. Another factor is the cost of the inventory of your goods at the beginning of the year. This should also correspond with the cost at the end of the last fiscal year.
There’s a specific formula you can use to calculate COGS. The cogs formula is:
(Beginning Inventory + Purchases) – Ending Inventory = COGS.
Beginning inventory is your inventory at the start of the year. It should match your inventory from the previous year. Purchases means inventory you bought during the year. Ending inventory is your inventory that remains unsold at the end of the year.
For example, say your business has a starting inventory of $15,000. Your purchases amount to $7,000 for the quarter and your ending inventory is $4,000. Using the cogs formula, it would be:
COGS = $15,000 + $7,000 – $4,000
Your COGS would be $18,000 for the quarter.
COGS and accounting methods
Once you’ve got the basics of the COGS formula down, there are several methods that can help dig deeper into the numbers.
First In, First Out (FIFO) inventory is a method that takes into account goods that are sold first. It usually applies to items that are perishable or have a shorter shelf life. When prices go up, companies that use FIFO tend to sell their less expensive products first and will often have lower COGS.
Last In, First Out (LIFO) is the opposite of FIFO. This refers to the last products added to inventory, which must be sold first. This will lead to higher COGS because as the cost of goods increases, goods with higher costs will sell first and your net income will decrease.
Inventory weighted average or weighted average cost method calculates the weighted average cost of products in stock. This price is used to assign inventory value to each unit. It’s often useful for mass-produced items.
Ratios and metrics related to COGS
There are a few other ratios and metrics that can be used with COGS to better understand a company’s financial health.
These are COGS Ratio, inventory turnover and gross profit margin:
COGS Ratio is used to determine the sales revenue percentage businesses use when it comes to expenses that directly vary with sales. The formula is:
COGS ratio = (COGs/ Net Sales) x 100
Inventory turnover is used to calculate how well a company can generate sales from inventory. It refers to how much a business has sold and replaced inventory in a given period. The formula is:
Inventory formula = COGS/ Inventory Average
Gross profit margin is the percentage of sales revenue a company retains after the costs from COGS. When the gross margin is higher, a business retains more from every dollar of revenue.
Why COGS matters
COGS calculations can help business owners stick to a budget and keep control of spending. It’s also an important metric to identify a company’s gross profit and gross margin. Higher COGS means a lower gross profit. Figuring out how to lower COGS is important for a company’s viability.
How to attain lower COGS
Once you determine your COGS, there are several ways to go about lowering it. Whether you’re a small business or a global one, it’s important to look at the whole picture. This doesn’t just include sales and marketing your products.
Examine your returns process and find ways to generate revenue during the exchange process. The first step is to ensure a painless process. A survey by Doddle found that a positive returns experience would convince 84% of consumers to shop from that brand again.
Make instant exchanges easy when the return is due to a sizing or style issue.
Employing upselling strategies is another way to increase revenue. This could involve offering the shopper a discount if they exchange the item for another product that might fit their needs more. Or you could offer an extra bonus credit if they buy another higher-cost item right then and there. This can help buyers feel like they are appreciated and are “winning” by gaining a higher-valued item.
You can also preserve a sale by encouraging shoppers to return the item in the store. 71% of in-store returns lead to an immediate purchase.
Want to learn more about lowering the cost of goods and implementing growth strategies? Book a demo with Loop today.