Cost of goods sold (COGS) means the direct costs involved in producing or delivering what a business sells. It is a key number used to calculate profit and manage pricing. This guide explains COGS in simple terms for beginners who want clear, practical answers.
What Is Cost of Goods Sold (COGS)?
Cost of Goods Sold, or COGS, is the direct cost of making or buying products or services that a business sells. It includes only costs that are directly linked to production or delivery.
COGS does not include operating expenses like rent, marketing, or office salaries. It focuses only on what it takes to produce the goods or services sold.
Why COGS Is Important
COGS matters because it directly affects profit.
- Lower COGS can increase profit
- Higher COGS can reduce profit
- Accurate COGS helps with pricing decisions
- COGS is required for financial statements and taxes
Without correct COGS, profit figures can be misleading.
COGS Formula Explained
The basic formula for COGS is:
COGS = Opening Inventory + Purchases – Closing Inventory
This formula is mostly used by businesses that sell physical products.
Example:
Opening inventory: ₦200,000
Purchases during the period: ₦500,000
Closing inventory: ₦150,000
COGS = ₦200,000 + ₦500,000 – ₦150,000 = ₦550,000
What Is Included in COGS
COGS includes only direct costs related to production or service delivery.
Common COGS items include:
- Raw materials
- Direct labor
- Manufacturing supplies
- Packaging costs
- Shipping for inventory purchases
These costs change based on how much you produce or sell.
What Is Not Included in COGS
Some expenses are often confused with COGS but should not be included.
These include:
- Rent and utilities
- Marketing and advertising
- Office salaries
- Accounting and legal fees
- General administrative costs
These are operating expenses, not production costs.
COGS for Product-Based Businesses
For businesses that sell physical products, COGS usually includes:
- Cost of inventory purchased
- Cost of materials used to make products
- Wages paid to workers directly involved in production
- Factory or workshop supplies
Tracking inventory correctly is essential to calculating accurate COGS.
COGS for Service-Based Businesses
Service businesses may also have COGS, though it looks different.
Examples include:
- Freelancers paying subcontractors
- Agencies paying project-based staff
- Service providers using materials for client work
Only costs directly tied to delivering the service should be included.
COGS and Gross Profit
COGS is used to calculate gross profit, which shows how much money remains after covering production costs.
Gross Profit Formula:
Gross Profit = Revenue – COGS
Example:
Revenue: ₦1,000,000
COGS: ₦550,000
Gross Profit = ₦450,000
Gross profit helps assess pricing and cost efficiency.
COGS vs Operating Expenses
COGS and operating expenses are often confused.
- COGS relates to production or service delivery
- Operating expenses relate to running the business
Both are important, but they appear in different parts of the income statement.
How to Record COGS in Accounting
COGS is recorded as an expense on the income statement.
A typical journal entry includes:
- Debit: Cost of Goods Sold
- Credit: Inventory
This entry reflects inventory being sold and recognized as an expense.
Common COGS Mistakes to Avoid
- Including rent or marketing costs
- Forgetting to adjust inventory balances
- Mixing personal and business costs
- Not tracking materials accurately
Avoiding these mistakes ensures accurate profit reporting.
How COGS Affects Pricing Decisions
Understanding COGS helps businesses:
- Set profitable prices
- Identify cost-saving opportunities
- Decide whether to scale production
- Understand break-even points
Without knowing COGS, pricing decisions may lead to losses.
Who Needs to Track COGS
COGS tracking is important for:
- Retail and eCommerce businesses
- Manufacturers and producers
- Freelancers with subcontracting costs
- Agencies delivering paid services
Any business that sells products or services with direct costs should track COGS.
FAQ About COGS
Q: Is COGS the same as expenses?
A: No. COGS includes only direct production or service delivery costs.
Q: Do freelancers have COGS?
A: Yes, if they pay subcontractors or incur direct project costs.
Q: Is inventory always part of COGS?
A: Only for product-based businesses. Service businesses may not use inventory.
Q: How often should COGS be calculated?
A: Monthly or quarterly for accurate reporting and decision-making.
Q: Does COGS affect taxes?
A: Yes. Higher COGS lowers taxable profit, while lower COGS increases it.
Conclusion
The concept of COGS requires understanding the direct cost of what a business sells. It is a key part of calculating gross profit and managing pricing. By tracking COGS accurately, freelancers, small business owners, and career switchers can make better financial decisions, report profits correctly, and run more efficient businesses.
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