Cost of Goods Sold (COGS)

Cost of Goods Sold, usually called COGS for short, is a really important idea in business. It has to do with how much money a company has to spend to make the stuff it sells. COGS is a key part of figuring out how much profit a company makes.

What is COGS exactly?

COGS means all the direct costs that go into producing the goods a company sells. It includes things like:

• The cost of the raw materials needed to make the products
• The cost of other supplies and ingredients used in production
• The wages paid to the workers who directly make the products

COGS is only about the direct costs of production. It doesn’t include other expenses like:

• The salaries of bosses and office workers
• Rent and utility bills for the office
• Advertising and marketing costs
• Interest on loans
• Taxes the company owes
• Depreciation (the loss in value of equipment over time)

Those are all important costs for a business too. But they aren’t part of COGS because they aren’t direct costs of making the products.

An example of COGS

Let’s say Emma has a bakery that makes and sells cookies. To figure out her COGS, Emma adds up:

• The cost of flour, sugar, butter, and other ingredients to make the cookies
• The cost of the electricity to run the ovens
• The wages she pays to the bakers who make the cookies

Emma doesn’t include things like:

• The rent for her bakery space
• The cost of her bakery’s website
• Her own salary for managing the bakery

Those are business expenses, but they aren’t direct costs of cookie production. So they aren’t part of her COGS.

How do you calculate COGS?

The basic formula for COGS is:

Starting Inventory + Purchases During the Period - Ending Inventory

The starting inventory is the value of all the raw materials and unfinished goods the company has on hand at the start of the time period, like the beginning of the year.

Purchases during the period means the cost of additional raw materials and supplies the company buys during that time to make more products.

The ending inventory is the value of the raw materials and unfinished goods left over at the end of the period.

COGS only counts the products that were actually completed and sold during the period. That’s why you have to subtract the ending inventory – those are supplies that weren’t used and products that weren’t finished and sold, so they don’t count in the current period’s COGS.

COGS calculation example

Let’s go back to Emma’s cookie bakery. It’s the start of 2021 and the value of her flour, sugar and other baking supplies is $2,000. That’s her starting inventory.

Throughout the year she spends another $10,000 on ingredients to make more cookies. Those are her purchases during the period.

At the end of the year, she has $1,500 worth of ingredients left over. That’s her ending inventory.

So for 2021, Emma’s COGS is:

$2,000 (starting inventory) + $10,000 (purchases) - $1,500 (ending inventory) = $10,500

That $10,500 represents the cost of all the ingredients that went into the cookies Emma actually baked and sold during 2021.

Why is COGS important?

COGS is a major factor in calculating a company’s gross profit. Gross profit is the company’s total sales revenue minus its COGS. It shows how much money the company made from selling its products, after covering the direct costs of making those products.

The formula for gross profit is:

Gross Profit = Net Sales - Cost of Goods Sold

If Emma’s cookie shop sold $50,000 worth of cookies in 2021, and her COGS was $10,500, then her gross profit is:

$50,000 (net sales) - $10,500 (COGS) = $39,500

This means that after covering her direct cookie-making costs, Emma has $39,500 left over. She’ll still need to use this money to pay her other business expenses like rent and marketing. What’s left after that is her net profit.

Gross profit and net profit are both important, but they tell you different things. Gross profit shows you how well the company is doing at the core business of making and selling products, before other expenses. If Emma has a high COGS compared to her sales revenue, it could mean she’s spending too much on ingredients, or not pricing her cookies high enough. Lowering her COGS or raising her prices could increase her gross profit.