Why You Need to Understand Your COGS
The world of today is driven by data and numbers. The more digits you can pin down to reflect your business’s operations, the better you will be able to highlight issues and identify savings opportunities. The costs your business faces are among the most critical of these numbers.
In this article, we’ll take you through a major component of your company’s expenses: the Cost of Goods Sold.
What Is the Cost of Goods Sold?
From labor payments to raw material expenses, businesses incur various costs when they attempt to sell products. COGS is an accounting term for such costs.
In general, the Cost of Goods Sold – COGS – is the cost businesses face when selling their products, and it is based on inventory valuation. This is the lowest cost for which a company can sell its goods without making a loss. Mathematically, adding your Initial Inventory + Purchases - Ending Inventory gives you the Cost of Goods Sold.
Note here that costs that are not associated with specific items are not included in the calculation. For example, you will add in the cost of packaging, not the storage rent or the price of a new machine.
COGS Accounting Methods
If your product sits in inventory for a long time, you can not quote its cost to be the same as the exact number you got it for, courtesy of inflation and currency depreciation. Companies mainly use the three inventory costing methods to monitor the inventory level sold per a given time period. These include:
1. First In, First Out (FIFO): FIFO assumes that the goods a company procures or produces first are sold first. As prices increase over time, a company using the FIFO approach essentially sells its cheapest goods first. This keeps their COGS low as compared to dealing in newer goods that have higher costs associated with them.
2. Last in, Last Out (LIFO): In stark contrast to FIFO, the LIFO method assumes that the goods manufactured latest are sold first. A company maintaining its reports through LIFO maintains an inventory full of older goods that reflect low costs, and this, in essence, can let you reduce the amount you pay in corporate taxes.
Though reduced tax liability sounds tempting, beware, for LIFO is complicated and, in many cases, will not paint the right picture of costs for you to analyze.
3. The Average Cost Method: The Average Cost Method uses the average costs of all goods in inventory, overlooking the purchase dates entirely. This protects the COGS from extreme peaks and dips in purchasing costs and price fluctuations.
How to Calculate the Cost of Goods Sold
Let’s delve into the topic through an example. Consider that your existing inventory is worth $20,000, and you made $10,000 worth of new purchases. Adding the numbers gives you $30,000 worth of goods available for sale. After the sale, if you’re left with an inventory worth $5000, your COGS will be:
COGS = Initial Inventory + Purchases - Ending Inventory
$20,000 + $10,000 - $5000 = $25,000
What Data Do You Need for COGS Calculations
COGS calculations aren’t as straightforward as additions and subtractions. Here’s a basic rundown of the information you’ll need to calculate the costs of goods sold.
1. The Initial Inventory Count: Inventory count will be relatively straightforward if you maintain a running count; otherwise, you’ll need to manually count your merchandise, raw materials, supplies, etc. Remember that this initial inventory count must match the inventory you were left with the previous year, or you’ll need to explain the difference when submitting your tax forms.
2. Direct and Indirect Costs: The direct costs are relatively straightforward and include expenses directly reflected in the end product, such as components and raw materials prices.
Indirect costs are more complicated, as you need to filter out the expenses that are specific to the product sale process. For example, you can not include your utility costs in COGS, as these are recorded as overheads and general expenses. You can’t factor in your marketing costs, payroll, insurance, etc., either. However, if you can tie an indirect cost with a product, like a commission paid to a salesperson or a contractor, you’ll make it a part of your COGS.
3. Inventory Additions and Purchases: You’ll have to track your purchases as you add inventory throughout the year. If you’re manufacturing goods yourself, your tax professional will guide you in recording the cost to add.
4. Final Inventory: You can either estimate or manually go through your final inventory. Make sure to deduct the value of damaged goods.
Why You Need to Understand Your COGS
Having precise data on your costs is crucial as it lets you know how much of a profit your company is making. COGS calculations and profit margins illustrate the sustainability of your business, too. If you’re always close to breaking even or are losing money due to incorrect cost estimates, you won’t continue running for long.
Additionally, a close analysis of all costs is the only way of revealing savings opportunities; even seemingly minute decreases in COGS can significantly increase your profit margins. Tracking your cost of goods sold shall also enable you to set precise numerical goals for your business that you can pursue to boost your income.
Should You Estimate the Cost of Goods Sold?
Suppose you’re not doing thorough calculations and sticking to estimates. In that case, you’ll likely have the advantage of not understating the costs – business owners often overestimate, making them work more to improve their profits. However, the approach is counterproductive because it does not generate a transparent picture of your business’s operations.
When your actual costs are obscured under the veil of estimations, you can not zoom into the details and devise intricate strategies to improve your profit margins.
If you do not have the expertise to calculate your COGS in detail, we’ll recommend either hiring someone or outsourcing.
Outsourcing is the most financially efficient way companies can proceed, especially if they’re seeing sudden rapid growth and do not have the experts to deal with the tax implications involved.
At Trusteer, our professionals are seasoned veterans in the world of taxes, accounts, and finances.
Contact us today so we can make sure nothing breaks your momentum.