How to Work Out Cost of Goods Sold (COGS) in Finance: Definition, Formula and Examples

Cost of Goods Sold Definition

COGS refers to the direct costs associated with producing goods for a business to sell.

 

This includes the costs of raw materials, direct labour, and manufacturing overheads:

 

  • Raw materials = These are the physical items directly used to make the final product.

 

  • Direct labour = The wages and benefits paid to workers who are directly involved in producing goods.

 

  • Manufacturing overheads = Indirect costs related to production that are not directly linked to a specific product, but still used in the production process.

 

COGS is a key part of the income statement, helping determine gross profit for a business.

 

The formula for gross profit is: Revenue − COGS

 

Therefore, subtracting COGS from total revenue highlights how profitable the core business activities are.

 

It is important to note that COGS is only relevant for businesses that sell physical goods.

 

Service based businesses typically do not have COGS, as they do not deal with inventory.

Cost of Goods Sold Formula

The formula to calculate the cost of goods sold is:

COGS = Beginning Inventory + Purchases − Ending Inventory

Where:

 

  • Beginning Inventory = The value of the inventory at the start of the period
  • Purchases = The cost of any additional inventory bought during the period.
  • Ending Inventory = The value of the inventory remaining at the end of the period

Cost of Goods Sold Examples

Example 1: COGS for a Retail Business

Imagine a small retail store which has the following data for the year:

Beginning Inventory

£10,000

Purchases

£40,000

Ending Inventory

£15,000

To calculate COGS:

 

COGS = Beginning Inventory + Purchases − Ending Inventory

COGS = £10,000 + £40,000 − £15,000 = £35,000

 

In this case, the cost of goods sold for the year is £35,000.

Example 2: COGS for a Manufacturer

Imagine a manufacturing company which has the following data for the year:

Beginning Inventory

£250,000

Purchases of Raw Materials

£500,000

Ending Inventory

£300,000

To calculate COGS:

 

COGS = Beginning Inventory + Purchases − Ending Inventory

COGS = £250,000 + £500,000 − £300,000 = £450,000

 

In this case, the cost of goods sold for the year is £450,000.

Impact of Inventory Valuation Methods on COGS

The way a business values their inventory can significantly affect COGS.

 

The three main inventory valuation methods are:

 

  • FIFO (First-In, First-Out): FIFO assumes the first units purchased are sold first.

 

  • LIFO (Last-In, First-Out): LIFO assumes the last units purchased are sold first.

 

  • Weighted Average Cost: This method calculates an average cost per unit of inventory, which is applied equally across all items of inventory, smoothing out price fluctuations.

Examples Using FIFO, LIFO and Weighted Average

Suppose you bought three batches of widgets:

Batch 1

100 units at £10 each

£1,000 total

Batch 2

100 units at £12 each

£1,200 total

Batch 3

100 units at £15 each

£1,500 total

Let’s calculate the inventory value after selling 150 units using FIFO, LIFO, and Weighted Average methods.

 

FIFO (First In, First Out)

 

Sold Units:

 

First, 100 units from Batch 1 at £10 = 100 × £10 = £1,000

Then, 50 units from Batch 2 at £12 = 50 × £12 = £600

Total Cost of Goods Sold (COGS) = £1,000 + £600 = £1,600

 

Remaining Inventory:

 

Batch 2: 50 units at £12 = £600

Batch 3: 100 units at £15 = £1,500

Total inventory value = £600 + £1,500 = £2,100

 

LIFO (Last In, First Out)

 

Sold Units:

 

First, 100 units from Batch 3 at £15 = 100 × £15 = £1,500

Then, 50 units from Batch 2 at £12 = 50 × £12 = £600

Total Cost of Goods Sold (COGS) = £1,500 + £600 = £2,100

 

Remaining Inventory:

 

Batch 1: 100 units at £10 = £1,000

Batch 2: 50 units at £12 = £600

Total inventory value = £1,000 + £600 = £2,100

 

Weighted Average

 

The weighted average cost per unit is calculated as:

 

Weighted Average Cost per Unit = Total Inventory Value / Total Units = £3,700 / 300 = £12.33 per unit 

 

Sold Units:

 

150 units × £12.33 = £1,849.50 

 

Remaining Inventory:

 

150 units × £12.33 = £1,849.50

 

Summary of Inventory Values

Method

COGS

Remaining Inventory

FIFO

£1,600

£2,100

LIFO

£2,100

£1,600

Weighted Average

£1,849.50

£1,849.50

As you can see, LIFO results in a higher COGS due to the higher cost of recent inventory, whereas the reverse is true of the FIFO method.