COGS, or Cost of Goods Sold, is essentially how much it costs you to produce your products or services. It includes all costs directly allocated to the goods or services sold in a given period. However, it does NOT include costs related to advertising, distribution, management, marketing or other indirect overheads. Only direct materials, direct labour and direct overheads can be included in calculating COGS.
Companies that don’t make a product, for example, retailers and wholesalers, often use the term cost of sales instead to refer to direct costs. Some businesses report both COGS and cost of sales separately if they make products and are involved in retailing or wholesaling.
How do you calculate COGS?
COGS is used to calculate your gross profit. So if your business creates a product for ZMW 900, incurring a ZMW 100 in direct overheads along the way and sells the product for ZMW 1,500 then the COGS is ZMW 1,000 and gross profit is ZMW 500.
The generally accepted formula for calculating COGS is:
COGS = beginning inventory + purchases during the period – ending inventory
However, what to include and how to calculate it depends on your type of business.
Wholesale & Retail:
In the case of wholesale and retail businesses, the cost of goods sold is the amount that was paid for the inventory items to be sold, plus any shipping costs or labour for delivery.
In the case of a manufacturer, inventory (and once sold, COGS) includes the cost of raw materials, labour to produce the item, and sometimes additional related costs.
Construction businesses may have many COGS accounts, ranging from Direct Labor, Materials, Subcontractor, and Indirect COGS (things like fuel, job supplies, equipment maintenance, etc).
What can you include in COGS?
Cost of direct material
This is the wholesale cost of the products or materials you use to either manufacture a product or sell a product in retail.
Cost of direct labour
This is the cost of direct labour used solely to create the product in question. No ancillary or indirect labour can be calculated as part of your COGS.
Cost of direct overheads
This is the cost of direct overheads utilised in the creation of the product.
Why is COGS important?
COGS is used to determine the profitability of a company, department, or product line. It makes it easier for managers to identify cost-saving measures and ways to save on inventory costs.