On the surface, the cost of sales seems like an easy number to calculate – you simply add up the amount you paid to create the inventory you sold to customers over a given period. When you start digging into it, however, it can be hard to figure out what counts as a production cost and what's a normal business expense. In simple terms, if you only incurred the expense to produce the product, then it gets factored into the cost of sales.
One way to calculate the cost of sales is by adding the beginning inventory to any purchases you make during the period, then deducting your ending inventory.
Cost of sales measures the cost of the inventory that a business sells during a certain period. "Cost" in this context includes all the direct costs it takes to create the item such as raw materials, labor, packaging and storage costs.
The key word here is "direct." Expenses you would have incurred anyway, regardless of whether you created any product, are disregarded. For example, a wedding photographer's cost of sales might include labor hours, film, flashbulbs and the album he creates for the happy couple. It would not include the rent on his studio space since he has to pay those costs whether he's servicing one client or one hundred clients.
For a service business like a law firm or a graphic design agency, the cost of sales will generally comprise the labor, benefits and payroll taxes of the fee earners who generate billable hours. That's because the things they need to do their work, like computer software, remain the same no matter how many hours they bill. For a wholesale business, the cost of sale will largely comprise the merchandise that was bought from a manufacturer.
Since the cost of sales is essentially the cost of doing business, it is recorded as a business expense on the income statement. Cost of sales is also known as the cost of goods sold, and the two terms are used interchangeably.
Suppose that you've just started a kitchen-table business selling T-shirts. You buy the shirts from the manufacturer at the cost of $5 per item, and it costs you $1 to wrap, label and ship each shirt. You sell the shirts for $8, making a profit or "margin" of $2 per T-shirt. At the beginning of the month, you decide to buy 100 shirts which you hope to sell during that month. Your total outlay is 100 x $5 or $500 in purchase costs.
However, you only sell 80 of those T-shirts with 20 T-shirts left over. Since those shirts cost you $5 each plus $1 for shipping, the cost of goods sold is 80 x $6, or $480.
For most businesses, a lot more goes into the cost of goods sold than the wholesale price of the product plus a bit of shipping. Other costs are tied to the production of the product, such as the cost of components, raw materials, labor and manufacturing overhead. An easier way to calculate the cost of goods sold when there are lots of costs to add up is by using the following formula:
COGS = Beginning Inventory + Purchases during the period - Ending Inventory
Inventory left over from the previous period comprises the "beginning inventory." You'll record anything you didn't sell during the last month, quarter or year. For our kitchen-table T-shirt entrepreneur, the fact that he's just starting means the beginning inventory is zero.
Just as the names suggest, "purchases made during the period" comprises any additional inventory or components you buy during the accounting period, or any extra labor you bring in to help produce your items. If the T-shirt seller ordered an additional 50 shirts from the manufacturer, these items would comprise his purchases during the year. The cost of these items gets added to the beginning inventory to give total inventory costs. At the end of the period, any products that you didn't sell are subtracted from the total inventory costs. The result is the cost of goods sold for the year.
Returning to the example of the kitchen-table T-shirt seller, if the same numbers are plugged into the COGS formula, you should get the same numerical result for the cost of sales. As a new business, this business has a starting inventory of zero, meaning he has no inventory left over from the previous month. He then bought 100 T-shirts at $5 each and sold 80 of them. For the 80 shirts as a group, he made $80 worth of additional purchases, in the form of packing and shipping at the cost of $1 per shirt. The remaining 20 shirts that didn't sell comprise his ending inventory, and he'll value them at cost, that is, 20 x $5 or $100.
Applying the COGS formula, you get:
$0 + $500 + $80 - $100 = $480
As you can see, the final figure is the same as the cost of sales figure calculation.
Deduct the cost of sales from the company's revenues, and you get the company's gross profit. Gross profit measures how efficiently a business is managing its supplies and labor in the production process and is an important indicator of the bottom line. If the cost of sales increases, gross profit will decrease. If the cost of sales goes down, gross profit will rise. While minimizing your gross profit may be beneficial for income tax purposes in some circumstances, overall, you will have less profit for your shareholders and less cash to reinvest in the business.
The conventional COGS formula assumes that the company is using a periodic inventory system. This system assumes that if an item of inventory is no longer located in the warehouse, it must have been sold to a customer. In reality, the item may have been moved, stolen, broken or rendered obsolete. So, the calculation might assign too many expenses to goods that were sold and distort the picture.
Businesses that use computerized inventory management systems are more likely to operate a perpetual inventory system where records are continually updated for received items, sold items, scraps and relocations. This should yield a high level of accuracy when it comes to calculating the cost of sales.
Another problem with COGS is that it's easily manipulated if the company wishes to cook the books. That's because the calculation relies heavily on the methodology the company uses to value its ending inventory. Consider the following to see how the cost of sales will change, just by switching up the valuation method:
- First In, First Out valuation assumes that inventory items are used or sold in date order, starting with the oldest item first. When prices are increasing, a business that chooses FIFO will sell its oldest, and therefore its cheapest, items first. This leads to a lower cost of sales.
- Last In, First Out valuation assumes that newer items are the first one used. Now when prices are increasing, the more expensive items are sold first, translating to a higher cost of sales.
- Average Cost Method averages out the cost of inventory items, regardless of the purchase date. This method smooths out any extreme price increases or decreases and gives a more consistent result.