Cost of Goods Sold

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Let’s explore What is Cost of Goods Sold

It is essential to understand that the below explanation and Cost of Goods Sold represents concept applicable only to manufacturing or to trading business.

It cannot be applied to the businesses, which provide services, since such businesses do not produce or sell goods. Therefore there will be no Inventory (manufactured or purchased) and there will be no Cost of Goods Sold.

• Cost of Goods Sold (COGS) – Direct costs, tied to the production of the goods a business sells. 

It includes:

• material cost
• direct labor cost
• overhead directly involved in creating the product

For the manufacturing or trading business it is important to understand that we must apply matching principle and match revenues earned with the costs incurred to earn such revenue.

Cost of Goods Sold – Financial Statements

From the picture below you can note that only costs of that inventory, which was sold during the particular period of time can be included into the Income Statement. All the inventory, which was not yet sold during the accounting period is accounted for in the Balance Sheet until is being sold.

Usually we analyse and account for transactions on already operating business, therefore the manufacturing and/or trading flow is continuous, i.e. inventory being purchased/manufactured, stored, sold and process runs again and again.

In order to understand how to calculate cost of goods sold, we will use the following Cost of Goods Sold formula:

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In the above formula costs in monetary means are being used. Only cost of inventory sold will go to the Income Statement and will be included into the Cost of Good Sold.

More simplified formula can look like this:

Cost of Goods Sold – Practical Example

Let’s take as an example bakery business.

To whip up the perfect Cost of Goods Sold (COGS) for a bakery, you’ll need to mix a few key ingredients. 🍰

• Start with a Base of Initial Inventory: Scoop up the total value of your pantry staples—think heaping piles of flour, sugar, and crates of eggs—ready at the dawn of your financial feast.
• Fold in Additional Purchases: Throughout the month, sprinkle in the cost of extra supplies. These are the fresh dollops of cream and chocolate chips that keep your bakery churning out delicious treats.
• Weigh Your Ending Inventory: As the month closes, weigh out what’s left on your shelves. This leftover mix is your ending inventory, ready to roll over into the next month’s recipe.
• Calculate Your COGS Soufflé: Now, subtract the value of your leftover ingredients from your initial mix plus the extra sprinkles added during the month. Voilà! The result is the true cost of the ingredients devoured in your month’s sales.

With this recipe, you’ll not only keep your financials as neat as your kitchen but also price your pastries perfectly to keep the dough rising in more ways than one! 🍞💸

Cost of Goods Sold – Importance

Cost of Goods Sold (COGS) is an essential measure in business that accounts for the direct costs of producing goods. It includes material and labor expenses but not indirect costs like marketing and sales. Calculating COGS is vital for several reasons:

• Pricing Strategy: It helps set profitable prices by understanding the baseline cost of products.
• Inventory Management: Efficient inventory control can reduce COGS and enhance profit margins.

Effective management of COGS is thus not only beneficial for accurate financial reporting, but also crucial for operational strategy and profitability

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Cost of Goods Sold (COGS) – Video Visuals

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Cost of Goods Sold (COGS) – Video Material

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