Inventory and Cost of Goods Sold

Inventory and cost of goods sold are two important factors in business. They help a business plan, forecast future needs, and keep track of expenses. Inventories can be tricky to calculate, but with the help of a calculator and some basic math, it’s easy to get an accurate picture of your company’s inventory levels.

Cost of goods sold is another important factor to watch for. This number tells you how much it costs your company to produce and sell its products. In this article, we will dive deep into each so you can be a pro in managing your inventory and cost of goods sold.

What is cost of goods sold (COGS)?

Cost of goods sold is the sum total of all costs associated with producing and selling a product. These costs can include direct production costs, such as wages and materials.

Cost of goods sold (COGS) falls between revenue and operating expenses on a company’s income statement. It includes materials, labor, and any costs associated with what a business spends to produce its products. To get accurate figures of a company’s gross profit, you must calculate the exact cost of goods sold and report it on the income statement.

This number can help assess how profitable a company is and plan future operations.

Understanding Cost of Goods Sold (COGS)

Many factors affect the cost of goods sold. This includes the cost of raw materials, products for resale, and labor. In order to calculate the cost of goods sold, businesses must first identify the costs associated with each stage of production.

The cost of goods sold (COGS) is one of a business’s most important financial measurements. It is used to calculate profit and loss, identifying areas where a company may be losing money. Understanding COGS can help you determine your business’s cash flow and whether those expenditures are necessary.

There are a few components to calculate when calculating the cost of goods sold.

1. The purchase price of the goods
2. The cost of materials and supplies used in production
3. labor costs

COGS is a critical financial measure that is subtracted by a company’s sales revenue to determine gross profit. The gross earnings measure measures a firm’s efficiency in managing its workers and supplies throughout production activities.

Because COGS are costs associated with a business operating expenses, they’re recorded as a business expense on the income statement. The cost of a product can be used to estimate the company’s bottom line. If COGS are high, the gross profit is reduced, resulting in a lower net income. Although these may benefit the taxpayer, they will lower the profit for shareholders.

What is included in the cost of goods sold?

COGS includes the cost of creating products a firm offers. These are typically direct costs of manufacturing the product.

The cost of materials includes the price of raw materials and the costs associated with processing these materials, such as taxes and freight when receiving the product. Labor costs include the wages paid to workers and the costs of benefits such as health insurance.

The direct cost incurred from the cost of goods sold are:

1. Products purchased for resale
2. Expenditures from freight-in
3. Storage costs, including factory overhead costs
4. Labor costs incurred
5. Materials for production
6. Returns and allowances through purchases
7. Shipping costs incurred when buying products to resale

COGS and Inventory

COGS is a term used in accounting for the “cost of goods sold.” Inventory is a term used in accounting to describe the assets that a business has on hand. The relationship between COGS and Inventory is important because it affects a company’s profitability.

A company’s COGS (cost of goods sold) reflects the cost of its items, while its inventory reflects the number of items it has on hand.

Inventory and COGS are related because inventory is a physical representation of the company’s current level of goods. In order to maintain a desired level of inventory, businesses must calculate the COGS for each product.

This will help determine how much money should be allocated to purchase new products versus expanding existing ones. Inventory can also be used as a measure of financial health, as it may indicate when a company is overproducing or underproducing goods.

COGS formula shows that COGS goes hand-in-hand with inventory. Different techniques for identifying and assessing the beginning and ending inventory may affect COGS greatly. The company generally conducts periodic physical counts for the amount of stock available at any given time to verify the stock’s availability.

These Physical Numbers are double-checking inventory records. In addition, they help companies locate deteriorated and obsolete inventory that has become obsolete or has been lost. Once the company knows the value of its stock, it can determine how much the total amount of inventory it has.

Before we calculate inventory and costs of goods sold, let’s understand inventory a little better.

What is included in the cost of inventory?

Inventory represents a tangible asset that an organization accumulates over time in order to meet future needs. The cost of inventory includes the costs associated with acquiring, producing, and holding the inventory. These costs can include the salaries of employees who work on the inventory, the cost of materials used to make the inventory, and the cost of storage space.

Think of it this way, when you buy something, the item’s price includes the cost of the item itself and the cost of getting it to you. The cost of getting an item to you might include the cost of buying it from a store and any shipping or transportation costs.

Now say you want to make some adjustments to use or sell your inventory. The amount you’ve incurred for converting the item is also included in calculating inventory costs. That can consist of paying staff, additional materials, and other variable or fixed costs.

Key Take Away, Inventory is one of the most important costs for businesses. It includes the cost of raw materials, work in process, finished goods, and storage space. In some cases, it can also include the cost of employee wages. The amount of an inventory cost depends on the type of inventory that a business has, the quantity of each item, and the market price of each item.

What are the different inventory methods?

Inventory methods are one way companies manage and measure their inventory. There are 4 main inventory methods: First In, First Out (FIFO), Last In, First Out (LIFO), Average Cost, and Specific identification method. Each has its own benefits and drawbacks.

FIFO

The FIFO Method is a way of organizing things in a specific order. It stands for “First In, First Out” and means that the first item you purchase will be the first item you sell. This is often used with food, where the oldest food is taken out first so it doesn’t spoil.

The advantages of the FIFO Method are that it is simple to understand and easy to use. It also ensures that the oldest items are processed first, which can be helpful in some situations.

The disadvantages of the FIFO Method are that it can lead to inventory shortages if demand for a particular item increases, and it can be difficult to track when items have been sold.

LIFO

On the other hand, the LIFO Method means that the last purchased item is the first one they sell. This is done by tracking the cost of each item as it enters and leaves the business.

The main advantage of the LIFO Method is that it reflects a company’s current financial position because it assigns the most recent costs of goods sold to the inventory account. This results in a lower cost of goods sold and higher net income on the income statement.

A disadvantage of the LIFO method is that it may not be allowed for certain types of businesses, such as those required to report their financial statements according to Generally Accepted Accounting Principles (GAAP).

Average cost method

The average cost method is a way of valuing inventory that takes into account the cost of all the items in inventory. It then divides that cost by the number of items in inventory. This gives you the average cost per item (average unit cost). When you sell an item, you use the average cost per item to calculate how much money you made on the sale.

The advantages of this method are that it is simple to use and takes into account the changes in the cost of individual items in the inventory. The disadvantage is that it does not consider the specific costs of items in the inventory.

Specific identification method

The specific identification method is a way of accounting for inventory that assigns the specific cost of each item to the inventory account. This method is used when the company has a large number of items with different costs. Under this method, the cost of the item is matched to the sale of the item.

The advantage of this method is that it provides more accurate information about the cost of inventory. The disadvantage is that tracking individual items is more time-consuming and costly.

How to calculate COGS and inventory costs?

The inventory cost calculation is a process that takes into account the cost of goods sold (purchases), the beginning inventory, and the ending inventory. The calculation determines the cost of goods available for sale. This calculation is used to determine the cost of goods sold during a specific period of time.

Let’s visualize the calculating cost of inventory and cost of goods sold

Inventory or COGS = (Beginning Inventory + Purchases) – Ending inventory

Now let’s look at an example

Say a company has a beginning inventory on their balance sheet for $80,000. They then purchased items at a value of $30,000 for that period. The company determined their ending inventory is $15,000. The inventory value would be established as such ($80,000 + $30,000) – $15,000, which will equal $95,000.

How do I calculate the cost of goods sold?

To calculate COGS, you need to know the beginning inventory, the amount of goods purchased during the period, and the amount of goods sold. The cost of goods sold is equal to the beginning inventory plus the purchases minus the ending inventory.

Cost of sale (COGS) is calculated by adding various direct costs needed for generating the business. Importantly, COGS is only based on direct costs incurred, which are directly associated with producing products in turn for revenue.

In contrast, indirect costs such as managers’ salaries, rentals, and electricity are not included. Inventory is an extremely important component of COGS.

How Does an Increase in Inventory Affect the Cost of Goods Sold?

An increase in inventory affects the cost of goods sold by increasing the amount of inventory on hand. This increase in stock will cause the cost of goods sold to be higher, as more items will need to be sold to break even.

When a company buys more goods than it sells, its stock of goods (inventory) goes up. This means the company has to subtract the value of its increased inventory from the total value of the goods it buys. This is like when you go shopping and have to subtract what you’re buying from the money you have in your wallet.

Purchasing more products can impact your cost of inventory than buying a few. With LIFO accounting, high prices could cause high COGS and a low gross margin. COGS applies primarily to products sold within a given period of time. It does not include inventory costs that are currently not being sold.

This is usually not a burden on financial statements. Instead, these surplus products will appear as assets under the inventory account on the balance sheet.

Exclusions from COGS

Some costs that a business has, like the rent for its building, are not related to making or selling products, so they are not included in calculating COGS. These costs are called “indirect” expenses.

COGS also excludes costs related to marketing and advertising the product. Although freight-in is included as direct costs, freight-out costs are excluded. 

Choosing an Accounting Method for COGS

The most common accounting methods for COGS are the cash method and the accrual method. The cash method records revenue when it is received and expenses when they are paid. The accrual method records revenue when it is earned and expenses when they are incurred.

It can vary depending upon the method of valuing a stock under GAAP. Different accounting practices produce different valued inventory values that affect COGS’ profits. 

Conclusion

COGS is a term that is used in accounting to describe the cost of goods sold. Inventory is the total amount of products that are available for sale. The relationship between cost of goods sold and inventory is important because it determines how much money the company makes.

Generally, COGS includes the cost of all sales within the accounting period. The reality, however, is that companies often have no idea how much stock they sell. Instead, a company’s inventory valuation methods rely on accounting principles. This includes the First In, First Out Rule (FIFO) and Last In, First Out rule (LIFO) to estimate their actual sales.

When COGS’s stock values are very high, it will cause a negative effect on the company’s gross profit. In order to improve reporting of profit, a firm will typically choose an accounting method containing fewer COGS figures.

The cost of goods sold is computed from the following equation: COGS = (Beginning Inventory + Purchases) – Ending inventory. Beginning inventory can be found on the balance sheet, and COGS are reported on the income statement.