Calculating Cost of Goods

Originally this post was going to be called “Figuring Your Cost of Goods,” but my wife saw the title and asked if “figuring” was a southern expression and did I mean to say “calculating”. Yes, and yes.  I don’t use southernisms often, but they do sometimes seep through.

Defining Cost of Goods: Cost of Goods Sold (COGS) refers to expenses that increase proportional to sales. For example, if you are selling cupcakes, it may take a pound of flour to make a dozen cupcakes; 2 lbs. to make 2 dozen, and about 100 lbs. to make 100 cupcakes. The amount of eggs, sugar, paper liners, and sprinkles used would also increase with more sales. These are also called as variable costs, because they vary directly and proportionally with the quantity of goods produced. This type of expense (flour) which is altered into your final product is a raw material.

Just to go ahead and draw the distinction, there is another type of expense known as fixed (or operating) costs. Fixed costs are mostly set and do not vary directly with sales. The rent for the kitchen is the same each month regardless of how many cupcakes are sold. Utilities are the same in that they have a fixed minimum each month. Your monthly power bill may be \$700 – \$1000 per month, but it doesn’t take 100 times more power to bake 1,200 cupcakes versus only baking 12. The fluctuations are likely to be impacted by factors other than the number of products produced.

Labor & Supplies: Depending on your business, labor is also likely to be a variable cost. In home construction or auto repair, labor would be variable based on the number of jobs. The same goes for retail even though the hours aren’t billed directly to the customer; there are usually a greater number of employees working during high volume periods versus slower times. This amount included in COGS generally only includes hourly employees rather (than salaried employees) since the same salary is paid regardless of sales fluctuations.

Supplies (also called indirect costs) can include parts or products used to make your goods where the cost per item is so small, it’s not worth the time to track how much is used per product. Examples of supplies could include ink, lubricants, cables, thread, paint or anything else that meets our two stipulations: The amount used goes up with increased production, but the amount used per product is minuscule.

Including Inventory: To calculate COGS we will need to add our Variable Costs (Raw Materials, Variable Labor, Supplies) and then either add or subtract the change in inventory for the period. Including Inventory Change accounts for both the materials still on hand and the materials depleted from inventory during the period. Without including this change the calculated costs will be either higher or lower than reality, and the whole point of tracking this is to give good, accurate information to help make decisions.

To determine Inventory Change, subtract Ending Inventory from Beginning Inventory:

 Ending Inventory 01/31/18 5,600 (minus) Beginning Inventory 01/31/18 10,450 February Inventory Change – 4,850

A couple of notes about this: In the example above, inventory decreased (ending is lower than beginning), so this represents a negative change. If your inventory value increases, the change will be positive. Also, the Ending Inventory of one period will be the Beginning Inventory of the next. Therefore, both inventory dates fall on the last day of the period.

Now let’s add this (even though we’re adding a negative number) to the other costs during the period.

 Period Raw Materials 30,125 Period Variable Labor 9,288 Period Supplies 550 Inventory Change –  4,850 Total COGS 35,113

COGS as a Percent: To make this number really useful, we want to convert it to a percentage of sales. To do this, divide your Total COGS by Sales. By using a percent, we can compare how our costs compare in periods with different sales and to industry averages. Generally, higher sales will notch down the percent while lower sales may push it higher.

 Total COGS 35,113 Sales ÷  109,890 COGS Percentage .3195 or 32%

Is My COGS Competitive? If you spent a long time in your industry, you may already have a good idea of your COGS targets. Otherwise, a site like bizstats.com may be useful to figure out industry averages for companies your size. The COGS for a grocer will be very different than that of a restaurant, and larger producers may pay lower prices for bulk purchases that a smaller producer cannot maintain. However, a smaller producer is likely to have less fixed costs and overhead making the competitiveness of your COGS directly relative to your business and industry.

What’s Next? Tracking and knowing your COGS each period has several benefits. It allows you to see (and research) spikes in production costs. If our 32% jumps to 42% in the following month with similar sales, we would want to investigate why and make immediate corrections. Knowing your COGS also allows reviews for product pricing. This could include both increases, decreases, or specialized discounts based on changing production costs.

As always, the purpose of accounting is to give owners accurate and timely information to make good business decisions. Last week, I made a post about calculating inventory and included a free inventory worksheet. The link below is another worksheet which can be used to calculate your COGS.

Cost of Goods Sold Template

One final note, the method of calculating COGS just reviewed is useful when using a Periodic Inventory method in which you count and update your inventory at the end of each period. The other method is to maintain a perpetual inventory system, in which integrated software adjusts your COGS each time a sale is made.