Benefits of using the cost of goods sold formula

February 18, 2024 by
Benefits of using the cost of goods sold formula
Office Dr. Abdel GhanY

Benefits of using the cost of goods sold formula

Cost of goods sold is an essential metric for any business producing or selling goods.

Some of the core benefits of using the cost of goods formula include:

  • The ability to assess your gross profit and understand the potential profitability of your business.
  • The insights gained into the production costs and the ability to see where costs may be lowered, or other savings made.
  • The clarity around which products may be more expensive than others to produce.
  • The ability to understand the ebbs and flows of costs and if those can be managed in a way that is beneficial to the business.

Cost of goods sold is a widely recognised way of assessing costs associated with manufacturing products. But there are variances in how it is handled, which means it can be prone to errors, miscalculations, and inconsistencies.

Let’s look at some of these risks now.

Risks of using the cost of goods sold formula

The COGS formula only takes direct costs into account. Any indirect costs, such as administrative and office costs, marketing and advertising, and rental expenses are not captured by the formula.

Expenses must be categorised appropriately and consistently every time a COGS analysis is done. Otherwise, the results can be badly skewed.

Three best-practice tips for using the COGS formula:

  • Use the same accounting system across the business so that when the full financial statements are done, the figures have all been assessed from the same baselines.
  • Calculate comparative points in time – such as when opening inventory and closing inventory – that have the same underlying assumptions.
  • Make sure the calculations are well recorded in time for the next COGS period. This ensures any variances in profits or losses over those periods can be compared.

Cost of sales vs. cost of goods sold

Cost of Sales and Cost of Goods Sold are often used interchangeably because they both reference the direct costs associated with producing or purchasing goods that are sold. However, they’re not always the same thing.

The main difference between COGS and cost of sales is that COGS refers to the cost of making a product, while cost of sales refers to the cost of a product which has been sold.

This means:

  • Manufacturers generally refer to the COGS because they can tie specific costs back to the production of tangible goods, such as labour, raw materials, and machinery used.
  • Service-only businesses generally lean toward the cost of sales because it is more difficult to assess the direct costs of a sale made.

Overall, the two terms are very similar as they’re used to reflect the cost of providing a service or goods, which is ultimately used to understand costs, revenues, and profit.

Cost of goods sold formula in accounting

Different accounting treatments can also yield different results of running the cost of goods sold formula.

The three most common inventory valuation methods used with COGS are:

  • The FIFO accounting method: First-In, First-Out (FIFO) assumes the items purchased or produced first are also the first to be sold.
  • The LIFO accounting method: Last-In, First-Out (LIFO) assumes the items purchased or produced first are the last to be sold.
  • The average cost method: Unlike FIFO and LIFO, this method takes the average prices of the various goods that are in stock, without considering the purchase date of those goods.

Using the average cost methodology, the COGS calculation is smoothed out over that time. This means that spikes or drops in demand and purchasing costs do not have an unjustifiable significant impact on the final figures.

Is cost of goods sold an expense?

Cost of goods sold is considered an expense for accounting purposes. This is because it represents direct costs incurred in the production or purchases of goods during the accounting period.

COGS is included in the financial statement as a line item because it’s directly responsible for generating information about the business’s costs and profits. However, COGS is different from other operating expenses such as marketing, office, or overhead costs.

Cost of goods sold journal entry (with examples)

Inventory accounting journal entries for cost of goods sold generally require debiting the COGS and crediting the inventory account.

It’s important to ensure the accounting is consistent across various entries, and that you’ve used the right formula to assess the cost of your business.

Generally, a journal entry will look something like this:

  • Date of the transaction
  • Debit: The cost of goods sold
  • Credit: Inventory
  • Credit: Purchases

We’ve outlined a couple of examples below:

COGS journal entry: Example 1

On December 6 last year, the balance of your opening inventory was $8,500. This consists of caps, T-shirts, and tracksuit pants.

Through the COGS period, you purchase wool and cotton to make more items, along with additional items such as elastic and pre-made logos. You also pay for labour to create the products. The cost of all this is $3,000.

At the end of your six-month COGS period, you have $2,350 of closing inventory.

COGS journal entry: Example 2

On Jan 18 this year the balance of your opening inventory was 50 designer light shades, each worth $2,000. Your opening inventory is therefore $100,000.

Over the next three months, you purchase 5 more of the same light shades, so your cost over this time is $10,000. You then sell 10, so your closing inventory is $90,000.

Opening Inventory: Formula & How to Calculate

Accurate inventory accounting requires accurate data. Opening inventory, correctly calculated, is an essential figure for determining the costs and profitability of your business. It can be used to calculate the cost of goods sold and other useful inventory reports.

Read on to discover everything you need to know about opening inventory, including the formula and how to calculate it.

What is opening inventory?

Opening inventory, also known as beginning inventory, is the total value of stock held by a business and able to be sold at the start of an accounting period. When calculated correctly, opening inventory should equal the ending inventory from the previous accounting period.

In manufacturing, opening inventory can include raw materials, assemblies, and finished goods. In retail and distribution, it most commonly refers to products that are available to be purchased by consumers.

There are several reasons why it’s important to know your opening inventory value.

The first is that this data can be compared with previous accounting periods to identify sales trends which can inform more accurate forecasting and smarter purchasing. This information can also feed into key decisions around how you manage your supply chain, where to increase or decrease business investment, and how to manage your labour force.

Another is that it’s a useful figure for calculating other financial metrics, such as cost of goods sold (COGS) and gross profit. Accuracy in these calculations is crucial for understanding which products and processes are making you the most money – and how much they’re making.

Opening inventory formula

To work out your opening inventory, you will first need to calculate your COGS and have a record of your total purchases and ending inventory from the previous period. Once those are ready, you can determine the figure using the opening inventory formula.

The opening inventory formula is:

COGS + Ending Inventory Value – Purchases = Opening inventory

To make it easy for you, here’s how you can get the inputs you need for the formula above.

How to calculate opening inventory

First, determine your cost of goods sold for the previous period. Cost of goods sold shows the total production and purchasing costs that are required to create and sell a product. It includes all elements of the production including materials, parts, and labour. It does not include indirect expenses such as marketing, or taxes.

Together with ending inventory – which can be determined by subtracting COGS from the sum of your previous period’s opening inventory and net purchases – you will be halfway towards knowing your opening inventory value.

Then simply subtract the total inventory purchase costs for the previous period to calculate your final opening inventory figure.

Here’s a summary of how to calculate opening inventory in four steps:

  • Calculate your COGS for the previous accounting period.
  • Calculate your ending inventory for the previous accounting period.
  • Add COGS and ending inventory together.
  • Tally up your net purchases for the period and subtract them from the previous figure.

Opening inventory valuation methods

Several methods can be used for valuing opening inventory. It’s important to choose the right accounting method for your business and to ensure it is consistent across all periods.

When deciding what accounting system to use, research your sector and national regulations. You will likely also need to draw on advice from a chartered accountant as there may be laws and accounting standards you will need to adhere to.

The three most common methods for calculating opening inventory are:

  • FIFO
  • LIFO
  • Weighted average

Let’s quickly recap how these work.

The FIFO method

The first-in, first-out (FIFO) method is where the products purchased or produced the least recently are the first to be sold to the customer. Goods are sold in an order determined by the date they were built or purchased from a supplier.

The LIFO method

The last-in, first-out (LIFO) method is the opposite of the FIFO method. Using LIFO, the most recent purchases are sold first. This allows businesses to mitigate any increasing costs of holding inventory. Notably, LIFO is only allowed under the US generally accepted accounting principles (GAAP). Companies that report under the International Financial Reporting Standards must use FIFO or the weighted average method

The weighted average method

The weighted average method calculates the average cost of a company’s inventory based on individual costs and divides them by the number available. The benefits of this method are that it’s far simpler to track and cuts back on paperwork and administration. We recommend this method for most businesses as it can save time and money when tracking inventory costs.

How to find beginning inventory with cloud software

Although the formula above can be useful for manual calculations, it requires a lot of input and tedious data analysis. You’ll need to have accurately tracked all your sales and expenses and attributed them correctly using specific inventory costing methods.

Done manually, this can take a long time – and be prone to errors.

The good news is that it’s possible to automatically determine beginning inventory using cloud software designed for this very purpose.

Cloud-based inventory management software tracks the value and movement of all your inventory throughout the year, automatically assigning costs and adjusting stock levels whenever goods are sold.

The relationship between opening inventory and closing inventory

Understanding the relationship between opening and closing inventory is key to delivering accurate inventory accounting and making decisions that result in maximised profit for your company.

The main way in which opening inventory and closing inventory are related is that the closing inventory for one period should be equal to the opening inventory for the following period.

These two inventory data points are also linked on a strategy level. They deliver the information required for you to assess ongoing expenditure, purchasing decisions, warehouse strategy, and labour management.

Here are some ways opening and closing inventory can help your business:

  • Opening inventory: Opening inventory reflects the value of your goods at the start of the period. It serves as a base figure for determining how much you’ve made, how much you’ve spent, and where you’ve spent it.
  • Closing inventory: Closing inventory provides a clear window into the costs and financial benefits of selling a product at a certain price point. Highlighting the sales and costs in a complete period can reveal where improvements should be made and where efficiencies can be gained.

Finally, both metrics figure into other key inventory formulas that enable better tracking of your general inventory management processes.

Why it’s important to know your opening inventory

Understanding your opening inventory is not just smart – it’s an essential part of running a business that deals with products.  

Opening inventory is important to know because it helps you:

  • File financial reports: Accurate reporting of the opening inventory figures will ensure your financial statements show the true financial health of your business, including the gross profit.
  • Comply with tax and payment obligations: As a responsible party, you are required to accurately report the financial health of your business and comply with tax obligations, including payments or any penalties that may accrue. This includes an accurate recording of your opening inventory for each period.
  • Report to investors, shareholders, and lenders: Your investors and shareholders will also have a keen interest in the company’s financial health. There may be trigger levels at which concerns are raised. Accurate opening inventory can assuage concerns about financial risk for investors.
  • Fully understand costs and profits: Opening inventory is essential for knowing the total costs and profits of your business, which feed into key decisions around purchasing and sales strategies.
  • Make smart strategic decisions: If your opening and closing inventory values reveal that the cost of certain items is too high, you can pull back on that product line. Conversely, if there is a large demand for a product you may want to focus more on that market niche.

Opening inventory: When to use it and why

The opening inventory financial metric is necessary when assessing the value of goods, materials, or costs at the start of an accounting period. But it also has other uses worthy of your consideration.

Here are some ways opening inventory can be useful in running your business:

  • Doing your financial reports: Opening inventory is a starting point from which you can determine the various inventory valuation figures you need to report on. It can also aid in checking in on the general financial health of your organisation at any given time.
  • Understanding the cost of goods: The opening inventory feeds into COGS, which tells you how much you’re spending on creating and selling goods – and where your margins are.
  • Gross profit analysis: The opening inventory figure is also a good indicator for the ultimate gross profit analysis (although the final analysis will likely include other variables).
  • Budgeting and financial planning: The opening inventory figure gives a window into what has happened during a specific period, which improves your ability to plan, budget, and strategize for the period ahead.

Total manufacturing cost formula

Total manufacturing cost can be calculated using the total manufacturing cost formula:

Direct Materials + Direct Labour + Manufacturing Overheads = Total Manufacturing Cost

The total manufacturing cost formula can be used alongside your net revenue to work out how profitably your business is producing goods. The higher your production costs, the thinner your profit margins are likely to be.

After using the total manufacturing cost formula to work out your overhead expenses, direct, and indirect costs, you can start to break down where inefficiencies in your production process exist.

For example, if you notice that indirect materials costs are driving up the total manufacturing cost in your manufacturing business, it would be wise to investigate alternative suppliers or types of material.