COGS. Books are written on this topic so the following is a simplified explanation intended for small businesses. Cost of goods sold are the direct variable costs of sales for the period. The best way to explain this is to break it down by industry type.
Service Industry. Traditionally, COGS for service industry businesses is always zero as there are no variable costs. But that model, I believe, is outdated and overly rigid for many service sectors. Take professional services. Advertising is a cost of sale that should fluctuate with the volume of sales. Sales must increase with additional advertising otherwise businesses wouldn't but it. Sales commissions, whether paid internally or externally, are variable expenses in that they are directly proportional to increased sales revenue.
Retailer / Wholesaler. Unless your business manufacturers something, traditional cost accounting says you have no direct labor costs. Thus, your COGS calculation is quite simple:
- Cost of products sold during period:
- Beginning inventory
- Plus: Purchases
- Plus: Freight-in
- Less: Ending inventory
Bar / Restaurant. Let's start with an simple example of the COGS calculation for a restaurant. Accountants may differ on the approach but a standard formulation for a restaurant's COGS for cost accounting purposes is the sum the following:
- Cost of food and beverages consumed during period:
- Beginning inventory
- Plus: Purchases
- Plus: Freight-in
- Less: Ending inventory
- Direct labor: kitchen staff
- Rent on the restaurant
- Lease payments on kitchen equipment
- Restaurant / bar supplies
Manufacturing business. The COGS calculation for manufacturing business is more difficult and best done by your accountant. Below is a suggested calculation of COGS for a manufacturing business although it's an oversimplication. Unless the business is able to use the specific identification method for inventory costing, assumptions must be made to assign costs to beginning and ending inventory (i.e., average cost method or first in, first out method, et alia). The first step is calculating your raw material costs:
- Beginning inventory
- Plus: Purchases
- Plus: Freight-in
- Less: Ending raw materials inventory
COCS calculation (sum of following):
- Material Cost of Products Sold:
- Beginning finished products inventory
- Plus: Beginning goods in process inventory (items in production pipeline at closs of prior accounting period)
- Plus: Raw material Costs for period
- Less: Ending finished products inventory
- Less: Ending goods in process inventory
- Direct labor (salaries and employment taxes for all employees involved in the manufacturer process)
- Indirect labor tied to manufacturing: manufacturing maintenance personnel, manufacturing supervisory personnel, et alia.
- Supplies and other materials used up in manufacture
- Warehouse costs
- Rent paid on building
- Lease payments on machines used in manufacturing process
- Freight out paid by
See Information from the IRS on the COGS calculation
See Wikipedia cost of goods sold article.
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