What is COGS? A concise guide for retail businesses

What is COGS? A concise guide for retail businesses
Adriano Casanova

As we’ve seen, COGS are costs or expenses that are closely tied to your revenue, margins, and net income. That’s why having an accurate valuation of your COGS metric will help you get a clearer picture of your business health. So let’s look at the parts that need to be accounted for in the COGS calculation.

  • Hence, the net income using the FIFO method increases over time.
  • So companies combine GAAP guidelines with logical approaches and apply them according to their particular situations.
  • Knowing the cost of goods sold helps analysts, investors, and managers estimate a company’s bottom line.
  • Let’s explore and organize the typical costs to ensure accurate accounting.

Interestingly, employee payroll can be classified as either type of expense, depending on the specific type of labor involved. Office payroll for secretaries, accountants, marketing specialists, and custodial staff would be classified as operating expenses. But payroll for an assembly-line auto worker would be directly tied to production, and would likely be categorized as a cost of goods sold. The Internal Revenue Service (IRS) allows companies to deduct the COGS for any products they either manufacture themselves or purchase with the intent to resell. This deduction is available to any business that lists COGS on its income statement, including manufacturers, wholesalers, and retailers, whether they operate in physical locations or only online.

Transportation-in costs should be allocated or assigned to the products purchased. Therefore, the unsold products in inventory should include a portion of the transportation-in costs. The products that have been sold, should have their share of the transportation-in costs in the cost of goods sold). If they are not an integral part of the final product, their costs are shipping or selling (normal business) expenses. If I sell items online and ship them to customers, as the shipper of the items (not the receiver of the items), do I count the shipping postage cost as a regular expense or as a COGS.

E-commerce solutions for managing cost of goods sold

However, for the DIY CEO, calculating cost of goods sold requires a bit of information prep beforehand in order to report accurately. Cost of goods purchased for resale includes purchase price as well as all other costs of acquisitions,[7] excluding any discounts. Since these costs are often not product-specific, many online retailers will come up with a per-unit cost that gets applied across the board to all goods sold as an average. This includes shelved items awaiting sale or those being incrementally phased into your inventory count. When inventory is artificially inflated, COGS will be under-reported which, in turn, will lead to a higher-than-actual gross profit margin, and hence, an inflated net income.

However; it is better to separate cost of the sold inventory from operating costs, for better business reporting and analysis. During times of inflation, LIFO leads to a higher reported COGS on your financial statements and lower taxable income. To find the weighted average cost COGS, multiply the units sold by the average cost.

Many people are familiar with standard shipping procedures and options; however, we’d like to help you take a closer look at shipping options so you can maximize profit and minimize frustration. To get the value of your inventory at the beginning and end of the year, you may need to do some kind of physical (or electronic) inventory. Check with your tax professional for help on the best way to get an accurate count. Personal Finance & Money Stack Exchange is a question and answer site for people who want to be financially literate. Stack Exchange network consists of 183 Q&A communities including Stack Overflow, the largest, most trusted online community for developers to learn, share their knowledge, and build their careers.

Understanding profit margin

Now, if we turn to GAAP, defining COGS components may not be that easy. Under GAAP, all operating expenses must be registered on the company’s books. However, there are no direct and specific instructions on how to categorize some expenses. That means that two companies may account for the same expense differently qualitative characteristics of financial statements and both of them might still be in compliance with GAAP. It’s necessary to stress that the cost of goods sold doesn’t include the expenses sustained to make the products that haven’t yet been sold during the specified period. Thus, only the cost of the products sold successfully is taken into account.

How to calculate COGS

Note that a higher cost of goods sold may mean paying less tax—but it also means your retail business is making a smaller profit. These costs come out of the margins just the same, but for tax purposes, they are kept separate. When business owners file their taxes, they need to provide a clear tabulation of the correct costs and their categories. Ultimately, business costs have a huge impact on the income of a business but also how they are taxed.

Cost of goods sold as a key performance indicator

It excludes indirect expenses, such as distribution costs and sales force costs. As you describe it, the freight out is a selling expense, not a cost of the goods. COGS includes the costs incurred in getting the goods converted/purchased/manufactured to the point that they can be sold. Some retail business owners use COGS as the basis for pricing their products. This strategy uses COGS as the baseline, or minimum price charged to the customer.

Therefore, this transportation-in cost of $40 amounts to $2 per book, resulting in a cost per book of $22. If 16 books are sold, the cost of goods sold will be $352 (16 X $22) and the inventory cost of the remaining 4 books will be $88 (4 X $22). In total, the bookstore had purchases of $400 + transportation-in cost of $40, resulting in the cost of goods available of $440. When we subtract the $88 cost of inventory, there is $352 as the cost of goods sold. By calculating all business expenses, including COGS, it ensures the company is offsetting them against total revenue come tax season. This means the company will only pay taxes on net income, thereby decreasing the total amount of taxes owed when it comes time to pay taxes.

Best Accounting Software for Small Businesses

It’s important to understand how to properly calculate cost of goods sold and determine what expenses should be included in it. If we look at the beginning or opening inventory, it’s basically the inventory that wasn’t sold during the previous year. Everything that’s manufactured and purchased during the year by a manufacturing or retail company is added to the beginning inventory. It’s necessary to clarify what we call inventory as there are different inventory costing methods that we will look into later in the article. In a retail setting, the cost of goods sold usually equals the price you pay a manufacturer or wholesaler to provide the product, in addition to shipping and handling. In your situation, the shipping expenses would be considered a normal/general business expense and not cost of goods sold.

That cost does not contribute to the manufacturing of the business’ product, so it is not part of COGS. Cost of goods sold (COGS) includes any expenditure that was necessary for the manufacture of a product sold by a company. It is solely made up of direct costs and can reduce a company’s tax liability. Costs of goods, unfortunately, only refers to what the final product in the customer’s hands costs. It does not include what the business had to pay to get it into their hands in the case of remote purchases.

How Operating Expenses and Cost of Goods Sold Differ?

COGS only applies to those costs directly related to producing goods intended for sale. COGS is calculated each year by showing changes in the company’s balance of “goods” or inventory, from the beginning to the end of the company’s fiscal (financial) year. As we explained earlier, COGS is a variable cost showing how much you spent on the merchandise before selling it to your customers. Reducing your cost of goods sold should be an ongoing process rather than a one-time endeavor as it helps you stay competitive while increasing profits over time. But since it represents such a fundamental element of many businesses, it needs to be addressed with the attention it requires. Yes, any kind of stock obsolescence is included as an expense and will reduce the value of stock on the balance sheet and will reflect in the value of Cost of Goods Sold in the P&L statement.