What happens when you ignore cost of goods sold (COGS)?

What happens when you ignore cost of goods sold (COGS)?

discover | Tuesday - 07 / 05 / 2024 - 12:28 am

In an aim to create suspense and excitement for the topic, some of you might prefer to postpone the answer to question in the title, but for us, we have no desire to postpone, especially when it comes to accounting errors such as “errors in calculating cost of goods sold (COGS)”!

Without properly calculating COGS, you will not be able to determine your profit margin (or whether you are making a profit in the first place).

Let’s start with a simplified definition of cost of goods sold (COGS):

COGS is the direct cost of producing the goods or services that a company sells or provides. This cost includes the cost of the materials used in production and the labor costs of workers involved in producing the goods or service.

Since it is deducted from revenue, COGS directly impacts the company’s profit. To put it simply, higher profits will be earned if the company reduces COGS through better deals with suppliers or by increasing efficiency in the production process.

The Importance of Cost of Goods Sold (COGS):

Cost of Goods Sold (COGS) is a crucial metric for any business. It goes beyond simply helping you determine pricing strategies, identify potential supplier changes, and pinpoint profit margin losses. COGS also plays a vital role in evaluating the overall efficiency of your company’s management.

By carefully assessing COGS, you can gain valuable insights that inform critical business decisions. For instance, you can determine:

– Whether or not you can afford to raise employee wages.

– Whether or not you need to switch to more cost-effective warehouses.

– Whether or not you can afford the expenses of updating equipment or renovating your workspace.

On the other hand, inaccurate COGS calculations can have detrimental consequences. Inaccurate COGS calculations can lead to an overestimation of your taxable income, resulting in higher tax payments. Moreover, poor COGS management can hinder your ability to secure loans when seeking to expand your business.

As you can see, dear reader, calculating COGS accurately is crucial for managing your company.

How to Calculate Cost of Goods Sold (COGS)?

Method 1:

You can calculate COGS using the following formula:

(Beginning Inventory + Purchases/Production for the Period) – Ending Inventory = COGS.

Beginning Inventory: The value of inventory at the beginning of the year (which is the same as the end of the earlier year).

Cost of goods: The cost of any goods that were purchased or manufactured during the year.

Ending Inventory: The value of inventory at the end of the year.

The above formula shows the cost of products produced and sold during the year.

Method 2:

The cost of goods manufactured or purchased is adjusted according to changes in inventory. For example, if 500 units were manufactured or purchased, but inventory increased by 50 units, the cost of 450 units is the cost of goods sold. If inventory decreases by 50 units, the cost of 550 units is the cost of goods sold.

Does cost of goods sold have other uses?

Answer: Yes, it helps in calculating inventory turnover rate, which is the number of times a company sells its inventory and replaces it with new one. Inventory turnover ratio can be calculated as follows: Cost of goods sold ÷ Average inventory = Inventory turnover ratio. This brings us to a crucial question:

What costs are included in COGS?

Typically, all direct costs associated with producing new products or purchasing inventory are included in a company’s cost of goods sold calculation. If you’re unsure whether or not to include a cost, ask yourself if the cost would show up in your accounts if you didn’t produce or purchase the goods. If it wouldn’t, then you probably include it in COGS.

Some of the most common examples of those costs are:

– Raw materials.

– Merchandise purchased for resale.

– Factory labor costs.

– Factory overhead costs.

– Warehousing costs.

– Shipping costs.

Then, what is excluded?

As we agreed, not all expenses can be considered as a cost of goods sold. Administrative expenses and selling expenses, which may include: office rent, accounting and legal fees, advertising expenses, management salaries, marketing costs… All these expenses are not included in the cost of goods sold because they are not directly related to the creation or acquisition of inventory, but are rather costs that keep the company going.

All non-operating expenses are also excluded from the cost of goods sold, including interest and capital expenditures.

Please note that the accumulated costs of producing products that remain unsold at the end of a specific accounting period are also excluded from the cost of goods sold. Instead, they are calculated as the opening inventory for the next accounting period.

Attention! Cost of Goods Sold (COGS) may not be enough!

While COGS is a very useful metric, it cannot do everything. For example:

It cannot effectively track inventory changes, especially those related to loss, theft, damage, or donations. Unless these changes are accounted for properly, they can distort your financial reports.

Obviously, COGS cannot be useful if it is calculated using inaccurate data. If you rely on inventory numbers in your records, any errors in these numbers will be reflected in COGS. Therefore, it is important to conduct a physical inventory to verify the accuracy of your records. This inventory will then allow you to calculate COGS accurately and with minimal impact from human error.

One problem with COGS is that it is relatively easy for unscrupulous accountants and managers to manipulate. They may try to allocate higher manufacturing costs, overestimate discounts and returns given to suppliers, or overstate the value of current inventory or change the value of closing goods. In all of these scenarios, your financial data will not accurately reflect your financial position, and this data could lead to an underreporting of COGS. This means that your reported gross profit margin will be higher than your actual profit, which will inflate your net income.

Fortunately, you can bypass all these nightmarish scenarios using Logix financial management system:

– The system is very rich in detailed, analytical, and comprehensive financial reports, leaving no room for error.

– The centralization of the system ensures that both deliberate manipulation and unintentional human error are difficult.

– The financial management system’s analysis tool allows you to automatically calculate the average number of units sold daily, in addition to knowing the available inventory, storage cost, and average cost per stored unit… all of which makes it easy for you to find the total cost of goods sold.

Now, what’s the next step?

Cost of goods sold (COGS) is an integral part of any business that purchases products for manufacturing or redistribution to customers. COGS must accurately reflect the true costs associated with your product to enable you to apply appropriate pricing. This is also a requirement for filing your income tax.

By understanding COGS and the methods for determining it, you can make informed decisions about your business. With Logix’s financial management system, you know you’re on the right track to a well-organized and efficient general ledger.

Smart Question:

Can the COGS be negative?!

Answer: Theoretically, yes… but in practice, this happens in rare cases due to either selling more units than the inventory of purchased goods or not purchasing any goods in an accounting period while generating revenue from a product purchased in a previous period. Therefore, (Beginning Inventory) + (Purchases) – (Ending Inventory) will result in a negative number. This is often an error resulting from manual data entry.