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.

What’s the difference between direct and indirect manufacturing costs?

It’s important to distinguish between direct and indirect manufacturing costs. When business costs relate to production activities they are generally classified as ‘direct’ or ‘indirect’. These can include the costs of raw materials, finished goods, production activities and customer service (but do not include administrative activities or period costs such as rental fees, utilities, office supplies, and office depreciation).

The key difference between direct costs and indirect costs is that direct costs can be tracked to specific item, and tend to be variable. Examples of direct costs include direct labour, materials, wages, commissions, and manufacturing supplies.

Indirect costs are likely to be fixed costs that include rent, insurance, quality control costs, depreciation, and the salaries of production supervisors and managers.

Direct materials costs

Direct materials are the inventory stock items used to create a finished product. Direct materials include raw materials, components and parts directly used in the production or manufacture of finished goods.

In coffee manufacturing, for example, the cost of coffee beans is a direct material cost. And for craft brewers, their direct material costs would include the yeast, hops and water used.

How to calculate direct material costs

To calculate direct material costs in a manufacturing business, add your beginning direct materials to your direct materials purchased and subtract the ending direct materials for the period.

The total direct material costs formula can be expressed as:

Beginning Direct Materials + Direct Materials Purchased – Ending Direct Materials = Total Direct Material Costs

For example, a coffee roaster has $2,500 worth of coffee beans at the beginning of the period, purchased an additional $4,000 worth of coffee beans and has $2,000 worth of beans left at the end of the period.

Total direct material costs = $2,500 + $4,000 – $2,000 = $4,500

Unlike fixed costs, which remain relatively constant, direct material costs are variable costs that fluctuate with varying levels of production activity, rising when output is increased and decreasing when production slows.

How to reduce direct material costs

Direct material costs can account for a significant portion of a company’s manufacturing expenses so how can you significantly reduce the material costs of inventory stock without affecting the quality of your final product? There are three common ways manufacturers do this.

1. Substituting lower cost materials

When looking to substitute materials for a lower-cost alternative, always ensure you are not compromising the quality of your product and potentially damaging your brand.

2. Manage your supply costs

Do some research – are there alternative suppliers available to you that can provide similar products at a cheaper price?

A couple of simple ways to substitute direct materials without compromising on the quality include sourcing from suppliers that can provide the same or similar item cheaper, or by reducing shipping costs through bulk purchases or buying local.

3. Reduce waste

A primary cause of waste in manufacturing is overproduction. Producing too much stock in advance means you are spending a lot more on direct material costs. Equally, you will also incur the costs of holding excess inventory stock or risk being left with stock you cannot sell.

Improved demand forecasting will minimise waste from overproduction. Implementing online inventory control software can help improve forecasting. Changing production methods to better utilise raw materials is another way manufacturer can reduce direct material waste.

Leveraging suppliers also helps. It is good practice to regularly evaluate your supply chain and to identify opportunities for improvement. Take advantage of any bulk-buy discounts or seasonal supply-side surplus to guard against off-season price increases.

Build effective supplier relationships to ensure that you get the direct materials you need when you need them. Good supply chain relationships mitigate the expense of material delays. Implementing service level agreements aid transparency, support product delivery schedules and help to maintain consistent materials quality.

Direct labour costs

Direct labour costs consist of more than just wages.

Costs include benefits for all staff who are directly involved in the manufacture and production of your product, such as:

• PAYE tax
• Superannuation contributions
• Holiday pay
• Sick leave entitlements
• Workers compensation insurance

This can include workers on the assembly line or employees that use machinery and equipment to manufacture the final product — the processing team, quality assurance inspectors, and warehouse staff responsible for delivering your finished goods.

How to calculate direct labour costs

Before calculating the direct labour costs per unit you need to know how to calculate the direct hourly labour rate and direct labour hours.

Step 1: Calculate direct hourly labour rate

The direct labour hourly rate is the sum of all wages, plus payroll taxes and fringe benefit costs for the period. Divide this amount by the number of hours worked in the pay period. The goal is to factor in variable costs – like staff with higher or lower pay rates – to gain a single value for the cost of an hour of work.

The formula to calculate direct hourly labour rate can be expressed as:

(Wages + Payroll Taxes + Fringe Benefit Costs) / Number of Labour Hours Worked = Direct Labour Hourly Rate

Step 2: Calculate direct labour hours

Next, calculate your direct labour hours.

This measures the number of working hours it takes to produce one unit. To calculate this, divide the number of units produced by the number of hours needed to produce them.

The formula to calculate direct labour hours can be expressed as:

Units Produced / Labour Hours = Direct Labour Hours

Step 3: Calculate direct labour cost per unit

Now that we know the direct hourly labour rate and the direct labour hours per unit, we can figure out the direct labour cost per unit by multiplying the direct hourly labour rate and the direct labour hours per unit.

The formula to calculate direct labour cost per unit can be expressed as:

Direct Labour Hourly Rate × Direct Labour Hours = Direct Labour Cost per Unit

Example: Calculating direct labour cost

Richard runs a coffee roasting facility where his team roasts and assembles 80kg bins of coffee.

He’s not making as much profit as he’d hope and he thinks it’s because his coffee isn’t priced correctly. He wants to know the direct labour cost of each bin of coffee to gauge whether he needs to change his prices.

Step 1: Calculate direct hourly labour rate

Richard has two staff members who earn $25 per hour, their payroll taxes costs $5 per hour and they have $3 worth of fringe benefit costs per hour. They each work 40 hours per week.

Total labour costs for these two employees are therefore: (25 + 5 + 3) × 40 =1320 × 2 staff members = $2640

One other staff member – a specialist coffee roaster – earns $35 per hour, with payroll taxes of $5 per hour and $3 fringe benefit costs per hour. They also work 40 hours per week.

The total labour cost in the period for this employee is therefore: (35 + 5 + 3) × 40 = $1720.

Richard’s total labour costs are therefore: $2640 + $1720 = $4360.

And the total hours worked by the three employees is: 40 × 3 = 120 hours.

Therefore Richard’s direct hourly labour rate is:

$4360 / 120 = $36.33

Step 2: Calculate direct labour hours per unit

Richard’s team can roast and assemble 150 bins of coffee in 40 hours.

Direct Labour Hours per Unit = 150 ÷ 40 = 3.75 hours

Step 3: Calculate direct labour cost per unit

Richard knows that his direct hourly labour rate is $36.33 and his direct labour hours is 3.75 hours.

Direct Labour Cost per Unit = 36.33 × 3.75 = $136.23

Now that Richard knows that it costs $136.23 to make each bin of coffee, he can decide to raise his prices to cover all his costs, or manage his labour costs, for instance by raising his productivity through more efficient manufacturing processes that reduce labour inputs per output.

Manufacturing overhead costs in detail

Manufacturing overhead is an indirect cost and includes:

• Taxes and depreciation on the manufacturing facilities
• Depreciation on manufacturing plant and equipment
• Salaries of employees such as managers, supervisors, quality control staff and maintenance teams
• The material cost of repairs and maintenance
• Utility costs such as electricity and gas used in the manufacturing facility

As an indirect cost, manufacturing overhead it is challenging to assign overhead costs to each of the units produced. For example, rent and insurance on the manufacturing plant are based on the assets’ value, not on the number of units produced. These indirect costs need to be apportioned to the units manufactured.

How to calculate manufacturing overhead

To find manufacturing overhead, identify the manufacturing overhead costs then add them up. Now you can determine the manufacturing overhead rate — this is the percentage of your monthly revenue that goes towards paying for overheads each month. To do this, divide the monthly manufacturing overhead by the value of your monthly sales, multiplying that by 100.

The formula to calculate manufacturing overhead is:

Overhead Costs / Sales × 100 = Manufacturing Overhead

For example, if your company has monthly manufacturing overheads of $60,000 and $490,000 in monthly sales, the overhead percentage is:

Manufacturing Overhead Rate = $60,000 / $490,000 x 100 = 12.24%

Therefore, 12.24% of monthly revenue will go toward the business’ overhead costs.

A low manufacturing overhead rate indicates that your manufacturing operations are utilising resources efficiently and effectively.

Why it’s important to allocate manufacturing overhead costs

Overheads directly impact a business’ balance sheet and income statement so it’s important to track and allocate these expenses. Allocating overhead helps you to identify areas to improve efficiency and reduce costs. It is important for pricing decisions because by incorporating indirect costs into pricing, you can cover costs by effectively pricing inventory stock to improve profitability.

Determining manufacturing overhead expenses also helps with budgets for manufacturing overhead. Knowing your manufacturing overhead costs means you can budget the money needed to cover these costs.

Total manufacturing cost versus COGS

Total manufacturing cost differs from the costs of goods (COGS). Where the total manufacturing cost is the total expense related to all labour and supplies used to create a finished product, COGS sold are simply the cost of finished inventory sold within the reporting period.