What Is COGS In Accounting

What Is COGS? #

If you own a small business, you need to know about the Cost of Goods Sold (COGS). It tells you how much money you make making the products or services you sell.

Understanding COGS helps you see if your business is making a profit. It also helps with pricing, budgeting, and tax calculations. If you don’t calculate COGS correctly, your financial records might not show the true picture of your business.

Which costs does COGS include? #

COGS includes all the direct costs of making your product or service. Here are the three main parts:

Direct Materials

Direct materials are the raw materials used in the production of goods. These materials are essential in creating the final product and are directly traceable to each unit produced. Without these materials, we cannot make the product.

Example:

A bakery needs flour, sugar, and eggs to make cakes. Each of these ingredients is a direct material. Bakers use them in baking and making the finished product. The company includes the cost of these materials in COGS because production consumes them.

Direct Labor

Direct labor includes the wages and salaries that companies pay to employees who directly make the product. These workers actively participate in the production process, and their labor costs directly affect the finished goods.

Example:

A bakery pays bakers to mix ingredients, bake cakes, and decorate them. Since their work directly creates the product, employers consider their wages as direct labor costs. Any overtime pay or bonuses related to production would also fall under direct labor expenses.

Manufacturing Overheads

Manufacturing overheads are indirect costs that support the production process but are not directly traceable to each unit produced. These costs include utilities, factory rent, equipment maintenance, depreciation of machinery, and other necessary expenses that keep the production process running smoothly.

Example:

A bakery pays for electricity to run its ovens. It also pays rent for the kitchen space and maintenance costs for the baking equipment. Even though these costs do not tie to a single cake, we consider them necessary for production and include them in COGS.

By tracking these costs closely, businesses can find their real production costs. This helps them set the right prices and boost profits.

Is COGS Important for Service-Based Businesses? #

If you run a service-based business (like a marketing agency or a consulting firm), you don’t sell physical goods. Even then, you still have costs related to what you provide.

For example, a graphic designer’s COGS may include the cost of design software and wages for employees. Tracking these costs helps business owners price their services correctly.

How to Calculate COGS #

COGS Formula:

COGS = Beginning Inventory + Purchases – Ending Inventory

Explanation:

• Beginning Inventory: How much stock you had at the start of a period.
• Purchases: Any new materials or products you bought.
• Ending Inventory: The items that remain at the end of the period.

Example:

A small toy store starts with ₹50,000 worth of toys. During the month, they buy ₹20,000 more. At the end of the month, they have ₹30,000 worth of unsold toys left.

COGS = ₹50,000 + ₹20,000 – ₹30,000 = ₹40,000

This means the store spent ₹40,000 on the products they sold.

How Does COGS Affect Profit? #

COGS helps calculate gross profit using this formula:

Gross Profit = Total Revenue – COGS

Example:

A bakery sells ₹1,00,000 worth of cakes in a month. Their COGS is ₹40,000.

₹1,00,000 – ₹40,000 = ₹60,000 Gross Profit

If COGS increases, the bakery makes less profit. If they reduce COGS (by finding cheaper ingredients without lowering quality), they can earn more.

Inventory Valuation Methods Affect COGS #

Businesses use different methods to track inventory costs:

1. FIFO (First In, First Out)

Sellers sell older stock first and then keep newer stock.

• Useful when product costs are rising.
• Keeps a lower COGS and shows higher profit.

2. LIFO (Last In, First Out)

The store sells newer stock first, and older stock remains.

• Used when prices rise to show higher costs and lower profits, reducing taxable income.

3. Weighted Average Cost

Uses the average cost of inventory over time.

• Smooth out price changes and keep consistent COGS.

How COGS Helps Small Businesses #

• Set the right price for their products.
• Reduce waste by monitoring inventory.
• Understand profits clearly.
• Improve budgeting for future expenses.
• Pay the right taxes by reporting the correct costs.

Challenges in Calculating COGS #

• Keeping Accurate Inventory Records – Wrong inventory counts can lead to wrong COGS calculations.
• Choosing the Best Calculation Method – Picking between FIFO, LIFO, or Weighted Average Cost affects reported profits and taxes.
• Managing Fluctuating Prices – If material costs change frequently, calculating COGS becomes tricky.
• Tracking Hidden Costs – Sometimes businesses forget to include packaging, transport, or wastage costs.

Best Practices to Manage COGS Effectively #

• Conduct Regular Inventory Audits – Check inventory frequently.
• Use Accounting Software – Tools like Vyapar app help track inventory, purchases, and sales.
• Reduce Unnecessary Costs – Cut costs without lowering quality.
• Educate Your Team – Train employees on inventory management.
• Consult an Accountant – Ensure accurate tax compliance.

How Vyapar App Helps #

Using Vyapar App makes managing COGS easier:

• Automated Inventory Tracking – Keeps track of materials and stock.
• Accurate Reports – Generates financial reports quickly.
• Easy Invoicing – Adds item details into bills.
• Tax Compliance (GST & Returns) – Helps stay compliant with GST rules.
• Expense Management – Tracks expenses for better profit margins.

FAQ’s: #

1. Why is COGS important for small businesses?

COGS helps businesses determine their actual production costs, set competitive prices, track profitability, and manage expenses effectively.

2. Can service-based businesses calculate COGS?

Yes, service-based businesses have costs of goods sold (COGS). This includes direct labor costs, software expenses, and other costs related to their services.

3. How does COGS impact taxes?

COGS lowers taxable income. Businesses subtract it from revenue to find gross profit. This reduces the amount of tax they owe.

4. What happens if COGS is too high?

A high COGS reduces gross profit, making it harder for a business to cover other expenses and remain profitable. Reducing waste and improving efficiency can help lower COGS.

5. What is the best method to calculate COGS?

The best method depends on the business. FIFO helps raise prices. LIFO is good for lowering taxable income. Weighted Average Cost is best for stability.

Conclusion #

COGS is a crucial financial metric that helps businesses understand their production costs, improve pricing strategies, and maximize profitability. By tracking costs accurately, businesses can manage their finances better.

They should choose the right inventory method. Using tools like Vyapar app can also help. This helps them achieve long-term success.