Cost of Goods Sold (COGS): Definition, Objectives, Elements, and How to Calculate It

The Cost of Goods Sold (COGS) is one of the key components in a company’s financial statements. This term is often used as a reference in determining the selling price of a product through the calculation of production costs.

By calculating the Cost of Goods Sold (COGS), companies can determine profit or loss. An accurate calculation of COGS affects the precision of the company’s reported profit. To obtain a correct, rational, and fair calculation, companies need to understand the determining factors before performing the calculation with specific formulas.

Definition of Cost of Goods Sold (COGS)

The Cost of Goods Sold or COGS can be understood as the total expenditures and expenses, both directly and indirectly incurred by the company, in order to produce goods or services.

Another definition of COGS according to accounting principles is the total expenditures and expenses allowed, both direct and indirect, to produce goods or services in the condition and location where the goods can be sold or used.

It is important to note that costs not directly related to the product cannot be included in the cost of goods sold. Therefore, this calculation is made so that the company knows the detailed cost of a product, as it relates to the profit generated by the company.

Objectives of Calculating Cost of Goods Sold (COGS) for Companies

As explained earlier, calculating COGS is important because it helps determine the company’s profit or loss. Beyond that, there are several other objectives of calculating COGS, namely:

1. Determining the Selling Price of Products

If the company does not know the total Cost of Goods Sold, it will be difficult to calculate and set the selling price of products.

Therefore, the company must know the components and costs in the production process as an initial step to set a selling price that ensures profit.

2. Monitoring Actual Production Costs

Next, the planned production costs will be monitored and analyzed to check whether they are realized according to plan or if there are discrepancies.

If differences occur, the company can identify the causes so that better decisions can be made in future production activities.

3. Periodic Profit and Loss Calculation

The purpose of knowing the value of the Cost of Goods Sold is to ensure whether production and marketing activities in a given period generate profit or result in losses for the company. This involves information on the company’s gross profit or loss.

4. Determining the Cost of Finished Goods Inventory

The company must be able to present data related to the cost of finished goods inventory and COGS, where these costs are attached to finished products that remain unsold as of the balance sheet date (included in the cost of goods in process).

Key Elements in Calculating Cost of Goods Sold

There are three main elements to consider in determining the Cost of Goods Sold: direct raw material costs, direct labor costs, and factory or company overhead costs. Here’s the explanation of each:

1. Direct Raw Material Costs

To produce goods, companies certainly need raw materials. In determining COGS, raw materials are one of the elements that must be included. Four types of costs are included here:

1. Amount of raw materials required

2. Capital used to purchase raw materials

3. Total remaining raw materials after production

4. Finalizing the need for raw material inventory

2. Labor Costs

Labor costs are predetermined through the wage or salary system provided to all company staff. With this payroll system, companies can measure labor needs for the production process. Therefore, this cost is also included in the COGS calculation.

3. Factory Overhead Costs

To determine the cost of a product, the company must also include factory overhead in the COGS calculation. Examples of overhead costs include maintenance and repair of factory equipment, procurement costs, management costs, accounting costs, and other resource expenses. In addition, taxes, depreciation of equipment, and factory construction can also be included as part of overhead costs.

How to Calculate COGS for a Company

The calculation and reporting of COGS differ across industries. Below are the steps for calculating COGS in one industry, namely manufacturing:

1. Calculating All Raw Materials Used

Manufacturing companies create products from raw materials, semi-finished goods, and then into finished goods ready for consumption. In this case, raw materials are the main capital in calculating COGS initially.

If the company is in manufacturing, it must first determine how much raw material will be used to produce goods. To determine this, look at the remaining raw materials at the end of the period, after the beginning balance, then add purchases made during that period.

Formula:

Raw Materials Used = Beginning Raw Materials + Purchases – Ending Raw Materials

2. Calculating Other Production Costs

Besides raw materials, manufacturing companies must also calculate other production costs that affect the process of turning raw materials into finished goods.

These costs include direct labor and overhead costs such as non-core raw materials (electricity, repairs, maintenance, etc.).

3. Calculating Total Production Costs

One point that distinguishes COGS calculations in manufacturing from other industries is determining the total production cost. Total production cost includes expenses incurred once the goods enter the production process and all related production expenses.

The calculation is obtained by determining the raw materials processed at the beginning of the production period, then adding non-core materials such as direct labor and overhead.

After calculating the total, the company then subtracts the remaining goods in inventory at the end of the period. The simplified formula is:

Total Production Cost = Raw Materials Used + Direct Labor Cost + Production Overhead

4. Calculating the Cost of Goods Sold

The formula to calculate COGS is:

COGS = Total Production Cost + Beginning Work in Process Inventory – Ending Work in Process Inventory

Get Accurate COGS Calculations with the Prieds System

To determine the amount of raw materials along with their costs, product requirements and specifications, and the entire production process, companies can use software as a tool to improve management accuracy and efficiency. Today, many companies across industries have adopted systems to optimize business processes. This makes it easier for companies to analyze and calculate business operations, including calculating the Cost of Goods Sold (COGS).

As a startup provider of customizable and integrable WMS software, Prieds offers solutions to improve business performance. With various features and modules, Prieds helps companies manage their operations effectively and efficiently. Supported by centralized data management, companies can more easily perform analyses to make business decisions. Additionally, complete and accurate stored data helps companies evaluate and increase profitability.

You can learn more about applying the Prieds system to your company by consulting with the Prieds expert team. Get a system with complete features and modules, top-level security, and ease of use tailored to your company’s needs.