Why knowing your COGS is important

The Cost Of Goods Sold (COGS) refers to the cost of producing an item or service sold by a business.

Key points

• Knowing how to calculate COGS can help determine if your business is profitable
• Calculating COGS correctly can inform a proper price point for an item or service
• Understanding COGS can help you better manage stock, tax and your business.

Correctly calculating the Cost Of Goods Sold

Calculate the COGS by adding the cost of stock at the start of the financial year to purchases made throughout that year. Then, subtract the cost of stock remaining at the financial year-end. The final number will be the yearly COGS for your business.

By subtracting the annual COGS from your annual revenue, you can determine gross profit. Remember, to arrive at an accurate COGS figure, you’ll need to value your stock.

The COGS may include:

• Materials used to create a product or perform a service
• Labour needed to make a product or perform a service
• Overhead costs directly related to production (for example, the cost of electricity to run an assembly line).

The Cost Of Goods Sold excludes:

• Indirect expenses (for example, distribution or marketing)
• Overhead costs associated with general business operations
• The cost of creating unsold stock or services.

There are other stock costing factors that may influence your overall COGS. The Australian Taxation Office refers to these methods as First In First Out (FIFO), Last In First Out (LIFO) and Average Cost.

Significance of COGS in Profit and Loss reporting

The Profit And Loss Statement or ‘P&L’ is a summary of business income and expenses over a specific period. Ideally it should be prepared at regular intervals (usually monthly and at financial year-end) to show the results of operations for a given period.

Profit or loss is calculated in the following way:

Sales — Discounts and Commissions = Net Sales — Cost Of Goods Sold = Gross Profit — Expenses = Net Profit

Calculating the COGS varies depending on whether a business is retail, wholesale, manufacturing or a service business:

• In retailing and wholesaling, computing for COGS during the reporting period involves opening and closing stock. This includes purchases made during the reporting period.
• In manufacturing, it involves finished-goods stock, plus raw materials stock, goods-in-process stock, direct labour and direct factory overhead costs.
• In the case of a service business, the revenue is derived from the activities of individuals rather than the sale of a product so therefore calculating COGS is a smaller task due to the low-level use of materials required to earn the income. Opening and closing work-in-progress, valued as time spent on jobs yet not billed, forms part of the COGS calculation in a service business.

Having accurate COGS data can help show you how your business is performing. Besides being a driver of business profit, it can help you set prices for your products.

To delve further into the concept of the COGS in your business, how to calculate it and how to apply it, contact the cloud business bookkeeping team at Notch Above Bookkeeping, Australia-wide, on 1300 015 130.