In this article, you will learn:
The formula to calculate the Cost of Goods Sold is:
COS = Beginning Inventory + Purchases – Ending Inventory
Where,
Benedict Company manufactures T-Shirts. The company is closing its books of accounts that showcases the following figures:
| Particulars | Amount in R |
| Beginning Inventory | R50,000 |
| New Purchases | R500,000 |
| Closing Inventory | R20,000 |
Now, here’s how you need to calculate the COS for Benedict Company Manufacturers.
COS = Opening Stock + Purchases – Closing Stock
COS = R50,000 + R500,000 – R20,000
COS = R530,000
Thus, from the above example, it can be observed that the cost of the merchandise that Benedict Company Manufacturers has to sell cost him R530,000 leaving the closing inventory of R20,000.
Such calculation of COS would help Benedict Company to plan purchases for the next financial year. In addition to this, the company can also determine the cost for each of its product categories and compare such costs with sales in order to determine the selling margin.
Such an analysis would help Benedict Company in determining the products that earn more profit margins and the products that are turning out too costly for the company to manufacture.
Merchandising and manufacturing companies generate revenue and earn profits by selling stock. For such companies, stock forms an important asset on their company balance sheet.
Merchandisers, including wholesalers and retailers, account for only one type of stock, that is, finished goods as they purchase the ready for sale stock from manufacturers.
On the other hand, manufacturers first purchase raw materials from suppliers and then transform these raw materials into finished goods. Therefore, manufacturers classify stock into three categories: raw materials, work-in-progress, and finished goods Work-in-progress stock is nothing but the stock that is still under process and is not yet converted into finished goods to be sold to customers.
Now, in order to record the cost of inventories in the books of accounts, manufacturers can either record the amounts of raw materials, work-in-progress and finished goods separately on the balance sheet or simply showcase the total stock amount.
Therefore, we can say that inventories and cost of goods sold form an important part of the basic financial statements of many companies.
International Financial Reporting Standards (IFRS) has stipulated three cost formulas to allow for inter-company comparisons. These include Specific Identification, First-In-First-Out (FIFO), and Weighted Average Cost Methods.
Thus, the type of method used by a company to value its stock has an impact on its ending stock and cost of sales. So in this article, let us try to understand what is the Cost of Sales, COS Formula, and different Stock Valuation Methods.
Cost of Sales (COS) refers to the costs associated with acquiring or manufacturing goods to be sold by a company during a specific period of time.
It includes only those costs that are directly incurred in order to manufacture the goods including the cost of labour, raw material, and overhead expenditure related to the manufacturing of goods to be sold.
The indirect costs such as sales and marketing expenses, shipping, legal costs, utilities, insurance, etc. are not included while determining COS.
Therefore, COS is calculated by adding the beginning stock and any further purchases made during the year and then subtracting closing stock from the sum of opening stock and additional purchases.
Beginning stock is nothing but the unsold stock at the end of the previous financial year. Whereas, the closing stock is the unsold stock at the end of the current financial year.
The cost of sales also referred to as Cost of Goods Sold is an important item on the income statement of your company as it helps in determining Gross Profit, a profitability measure that demonstrates the efficiency of your business in managing raw material and labour.
Product Cost refers to the costs incurred in manufacturing a product intended to be sold to customers. These costs include the costs of direct labour, direct materials, and manufacturing overhead costs.
In terms of services, product cost is the cost incurred on the labour required to deliver the services to customers. In the case of services, product cost must include all the costs that are associated with rendering services like employee compensation, employee benefits, and payroll taxes. or costs incurred in rendering a service to the final users.
Now, it is important for you as a business to calculate the per unit product cost as it helps you in setting an appropriate selling price for your product. Typically, the per-unit cost of your finished goods is derived by adding the costs incurred to produce a bunch of units and then dividing this cost by the number of units in the batch so produced.
Per Unit Product Cost = (Total Cost of Direct Materials + Total Cost of Direct Labour + Total Cost of Direct Overheads) / Total Number of Units
So, the cost of goods that are not yet sold but are ready for sale can be recorded as stock (asset) in your balance sheet. However, as soon as such goods are sold, they become a part of the Cost of Sales and appear as an expense in your company’s income statement.
The Product Cost and Cost of Sales are a few of the most important metrics on your financial statements. It is important to determine product pricing and COS as it helps you to:
The Product Cost helps you to determine the selling price of your finished products and know whether your business has earned profits, incurred losses, or has achieved the break-even point.
If the per-unit selling price is greater than the per-unit cost of the product, then your business has earned profits. While if the per-unit selling price is less than the per-unit cost of your products, this means your business has suffered losses.
And to break even, the per-unit cost must be equal to the per-unit selling price of your products, that is, your selling price must cover the per-unit cost.
COS helps you to determine the gross profit for your business which is nothing but the difference between Revenues or Sales and COS. It is the Gross Income that your business earns before subtracting taxes and other expenses.
Gross Profit is an important metric as it indicates the efficiency with which your business operates. It lets you know how efficiently your business is utilising its labour and raw materials to manufacture its finished products.
Gross profit also helps to determine Gross Profit Margin, a percentage that indicates the financial health of your business.
COS is the cost incurred in manufacturing the products or rendering services. It is recorded as a business expense on the income statement of your company.
Thus, by calculating COS, various stakeholders of your company like managers, owners, and investors can quote your company’s net income. Net income is the net earnings of your business that is calculated by deducting COS and other expenses like Selling and Administrative Expenses, Operating Expenses, Depreciation, Interest, and Other Expenses from Sales or Revenue.
If COS increases, the net income decreases which means fewer profits for your business. Therefore, it is important for you as a business to keep COS low in order to earn higher profits.
In the above section, the basic COS Formula was discussed. In this section, we are going to discuss COS Formula extended charting out different components in detail.
COS = Beginning Stock + Raw Material Purchase + Cost of Direct Labour + Overhead Manufacturing Cost – Ending Stock
Where,
Following are some of the basic examples that would help you in explaining how to calculate COS using the COS Formula extended. Let’s consider the example of Benedictt Company that manufactures T-Shirts.
Benedictt Company manufactures T-Shirts. The direct cost of manufacturing a T-Shirt is R20. Following are the figures pertaining to the year ending 2019:
| Particulars | Description |
| Beginning Stock | 100,000 T-Shirts |
| Purchase | R300,000 |
| Ending Stock | 40,000 T-Shirts |
| Cost of Sales | R27,000 |
Cost of Opening Stock = 100,000 x R20 = R2,000,000
Cost of Closing Stock = 40,000 x R20 = R800,000
Therefore, Cost of Sales is calculated as mentioned below:
COS = R2,000,000 + R300,000 – R78,000 + R168,000 – R800,000
COS = R1,590,000
Now suppose that Benedictt Company starts manufacturing Lowers apart from T-Shirts. Following are the figures of both the products pertaining to the year ending 2019:
| Particulars of T-Shirts | Description |
| Opening Stock | 40,000 T-Shirts |
| Closing Stock | 5,000 T-Shirts |
| Costs Incurred During the Year | |
| Cost of one T-Shirt | R20 |
| Cost of material | R200,000 |
| Cost of Labor | R800,000 |
| Particulars of Lowers | Description |
| Opening Stock | 20,000 Lowers |
| Closing Stock | 2000 Lowers |
| Costs Incurred During the Year | |
| Cost of one Lower | R40 |
| Cost of material | R300,000 |
| Cost of Labor | R1,000,000 |
In addition to the above direct costs, there are some overhead costs that Benedictt Company had to incur. These are mentioned below.
COS is calculated as follows:
The following table shows the Direct Cost of manufacturing T-Shirts.
| Particulars of T-Shirts | Units | Per Unit Cost | Total Cost |
| Opening Stock (A) | 40,000 | R20 | R800,000 |
| Closing Stock (B) | 5,000 | R20 | R100,000 |
| Direct Cost | |||
| Cost of material | R200,000 | ||
| Cost of Labor | R800,000 | ||
| Total Direct Cost (C) | R100,000 | ||
| COS (A+C-B) | R800,000 |
| Particulars of Lowers | Units | Per Unit Cost | Total Cost |
| Opening Stock (A) | 20,000 | R40 | R800,000 |
| Closing Stock (B) | 2,000 | R40 | R80,000 |
| Direct Cost | |||
| Cost of material | R300,000 | ||
| Cost of Labor | R1,000,000 | ||
| Total Direct Cost (C) | R1,300,000 | ||
| COS (A+C-B) | R2,020,000 |
Now, let’s take an example of a food delivery services company, Zoot, that picks up parcels from various suppliers and delivers it at the doorstep of the consumer. Below are the costs incurred during 2019.
In addition to the above mentioned costs, there might be other costs including marketing, travelling, administrative, and selling expenses. Since all these costs are indirect costs, these would not be considered while calculating COS of Zoot for the year 2019.
COS = R400,000 + R10,000,000 + R50,000 = R10,450,000
COS is an important metric on the income statement of your company. This is because the COS has a direct impact on the profits earned by your company.
Now, it is important to note here that Gross Profit, which is a profitability measure, is calculated with the help of COS. Thus, Gross Profit is nothing but the difference between Revenue and Cost of Sales.
As mentioned earlier, the Gross Profit is a profitability measure that reveals how efficiently your business manages its labour and supplies in the manufacturing process. That is, higher the COS, lower is the Gross Profit and lesser the COS, higher the Gross Profit.
But Gross Profit alone would not help in comparing the efficiency of your business from year-to-year or Quarter-to-Quarter. Therefore, in order to achieve that, you need to calculate Gross Profit Margin.
Gross Profit Margin is a percentage metric that measures the financial health of your business. It is calculated by dividing Gross Profit by Net Sales. Thus, if Gross Profit Margin fluctuates to a great extent, it may indicate inefficiency in terms of management or poor quality of products.
As the name suggests, under the Periodic Stock system, the quantity of stock in hand is determined periodically. All inventories obtained during an accounting period are recorded as Purchases.
Thus, total purchases at the end of the accounting period are added to the opening stock to calculate the cost of goods available for sale. Then, in order to calculate COS, the ending stock is subtracted from the cost of goods available for sale so calculated.
It is important to note that under the Periodic Stock System, the stock left at the end of the year (closing stock) is counted physically.
Furthermore, under this method, there is always a chance of committing an error due to improper entry or failure to prepare or record the stock purchased. As a result, the recorded stock may differ from the actual stock.
Therefore, physical periodic verification of the stock records is required. The physically counted stock is then compared with the recorded stock and is corrected to match with the quantity actually on hand.
Let’s consider an example to understand how COS is calculated under the Periodic Stock System.
Crompton Pvt Ltd had the following transactions during the current financial year.
| Particulars | Cost |
| Beginning Inventory | 100 units at R6 per unit = R600 |
| Purchases | 900 Units at R6 per unit = R5,400 |
| Sales | 600 Units at R12 per unit = R7,200 |
| Ending Inventory | 400 Units at R6 = R2,400 |
Therefore, the COS under the Periodic Stock System is:
COS = Opening Stock + Purchases + Closing Stock
COS = R600 + R5,400 – R2,400 = R3,600
Under the Perpetual Stock System of stock valuation, only increases and decreases in the quantity of stock (not the rand amounts) are recorded in detail. This system of stock helps in determining the level of stock at any point in time.
That is, this method of stock management records the sale and purchase of stock thus providing a detailed record of the changes in the stock levels. This is because the stock is immediately reported with the help of management software and an accurate amount of stock in stock as well as on hand is reflected.
That is to say, the Perpetual Stock System records real time transactions of the stock purchased or sold using an stock management software.
Let’s consider an example:
The First In First Out Method is based on the assumption that the goods are used in the sequence of their purchase. This means that goods purchased first are used or consumed first in a manufacturing concern and are sold first in case of a merchandising firm.
Accordingly, in FIFO method of stock valuation, goods purchased recently form a part of the closing stock. Now, in order to better understand the FIFO method, let’s consider the example of Harbour Manufacturers.
In this case let’s consider that Harbour Manufactures use a periodic stock management system and FIFO method to determine the cost of ending stock. Now, the cost of closing stock is calculated by taking the cost of the latest or the most recent purchase and then calculating backwards till the time all the items in stock are considered.
Suppose Harbour Manufacturers made the following transaction in its first month of operations:
| Date | Purchases | Sold | Balance |
| October 8, 2019 | 2,000 Units at R4.00 | 2,000 Units | |
| October 14, 2019 | 6,000 Units at R4.40 | 8,000 Units | |
| October 18, 2019 | 4,000 Units | 4,000 Units | |
| October 30, 2019 | 2,000 Units at R4.75 | 6,000 Units |
From the above table, we can calculate the cost of ending stock of 6000 units and cost of goods available for sale (beginning stock + purchases) of R43,900 (2000 units @ R4.00 + 6000 units @ R4.40 + 2,000 @ R4.75).
Now, to calculate the cost of ending stock and COS, FIFO method is used.
| Date | Number of Units | Unit Cost | Total Cost |
| October 30 | 2,000 | R4.75 | R9,500 |
| October 14 | 4,000 | R4.40 | R17,600 |
| Ending Inventory | 6,000 | R27,100 |
Thus,
Cost of Sales Available for Sale R43,900
(-) Ending Stock R27,100
Cost of Sales R16,800
Case II – Under Perpetual Stock System
In this case, we will consider that Harbour Manufacturers uses the perpetual stock system and FIFO method to calculate the cost of ending stock and COS.
Thus, in this case, cost is attached to each withdrawal or sale of items. Accordingly, goods sold on October 18, 2018 would comprise of purchases made on October 18, 2019 would comprise of purchases made on October 8, 2019 and October 14, 2019.
| Date | Purchases | Sales | Balance |
| October 8, 2019 | 2,000 @ R4.00 = R8,000 | 2,000 @ R4.00 = R8,000 | |
| October 14, 2019 | 6,000 @ R4.40 = R26,400 | 2,000 @ R4.00 + 6,000 @ R4.40 = R34,400 | |
| October 18, 2019 | 2,000 @ RRs 4.00 + 2,000 @ R4.40 = R16,800 | 4,000 @ R4.40 = R17,600 | |
| October 30, 2019 | 2,000 @ R4.75 = R9,500 | 4,000 @ R4.40 + 2,000 @ R4.75 = R27,100 |
As per the above table, on using the FIFO method, sales made on October 18, 2018 would comprise of:
Thus, the ending stock according to this method is R27,100 and the cost of sales is R16,800.
The LIFO Method assumes that recent goods purchased are consumed first and the goods purchased first are consumed later.
Thus, the cost of goods sold is calculated using the most recent purchases whereas the ending stock is calculated using the cost of the oldest units available.
In this case let’s consider that Harbour Manufacturers use a periodic stock management system and LIFO method to determine the cost of ending stock.
Now, if the company uses a periodic stock system, it is considered that the total quantity of sales made during the month would have come from the latest purchases.
| Date | Units | Unit Cost | Total Cost |
| October 8, 2019 | 2,000 | R4.00 | R8,000 |
| October 14, 2019 | 4,000 | R4.40 | R17,600 |
| Ending Inventory | 6,000 | R25,600 |
Goods Available For Sale R43,900
(-) Ending Stock R25,600
Cost of Sales R18,300
Hence, as per the above table, 4,000 units sold on October 14, 2019 would comprise of:
In this case let’s consider that Harbour Manufacturers use a perpetual stock management system and LIFO method to determine the cost of ending stock. Therefore, the ending stock and cost of goods sold would be different as against the periodic stock system.
| Date | Purchases | Sales | Balance |
| October 8, 2019 | 2,000 @ R4.00 = R8,000 | 2,000 @ R4.00 = R8,000 | |
| October 14, 2019 | 6,000 @ R4.40 = R26,400 | 2,000 @ R4.00 + 6,000 @ R4.40 = R34,400 | |
| October 18, 2019 | 4,000 @ R4.40 = R17,600 | 2,000 @ R4.00 + 2000 @ R4.40 = R16,800 | |
| October 30, 2019 | 2,000 @ R4.75 = R9,500 | 2,000 @ $4.00+ 2,000 @ $4.40 + 2,000 @ R4.75 = R23,600 |
As per the above table, on using the LIFO method, sales made on October 18, 2019 would comprise of:
Thus, the ending stock according to this method is R23,600 and the cost of sales is R17,600.
The COGS to Sales ratio showcases the percentage of sales revenue that is used to pay for the expenses that vary directly with the sales of your business. This ratio indicates the efficiency of your business to keep the direct cost of producing goods or rendering services low while generating sales.
Therefore, the lesser the ratio, the more efficient is your business in generating revenue at a low cost. That is to say that the decreasing COGS to Sales ratio indicates that the cost of producing goods and services is decreasing as a percentage of sales.
However, an increasing COGS to Sales ratio would inculcate that the cost of generating goods or services is increasing relative to the sales or revenues of your business. Thus, there is a need to control the costs in order to improve the profit margins of your business.
This ratio also helps the investors in deciding the company stocks in which they must invest for a profitable portfolio. Thus, investors before investing in company stocks research the industry the business operates in and track the COGS to sales ratio in order to know the costs relative to the sales.
By tracking such a figure for a host of companies, they can know the cost at which each of the companies is manufacturing its goods or services. Thus, if one company is manufacturing goods at a low price as compared to others, it certainly has an advantage as compared to its competitors as more profits would flow into the company.
Thus, as an investor, you certainly need to be aware of the risks pertaining to higher COGS that companies may face.
The formula for COGS to Sales Ratio is as follows:
COGS to Sales Ratio = Cost of Goods Sold/Sales
Suppose, Harbour Manufacturers has a Cost of Goods Sold of R100,000, the Sales for the current year is R200,000, and Sales return amounts to R50,000. Then,
Net Sales = R200,000 – R50,000 = R150,000
COGS to Sales Ratio = R100,000/R150,000 = 66.67%
It is probable that during a given accounting period, your business might purchase stock at several different prices. Now, since the inventories are purchased at different prices, the challenge that arises is to divide the cost of goods available for sale between the cost of goods sold and the ending stock.
Therefore, to overcome this challenge, various stock valuation methods are used and the method thus selected has a great impact on the reported income of your business. Thus, you should choose such a method that clearly exhibits income of your business during a given accounting period.
Following are the methods of stock valuation that are applicable to both manufacturing and merchandising inventories.
The First In First Out Method, also known as FIFO Method, is a method of stock valuation that is based on the assumption that the goods are consumed in the sequence in which they are purchased.
This means the goods purchased first are consumed first in a manufacturing concern and in case of a merchandising firm are sold first.
Accordingly, under FIFO method, goods purchased recently form a part of the closing stock.
The benefit of using FIFO method is that the ending stock is represented at the most recent cost. Thus, FIFO method provides a close approximation of the replacement cost on the balance sheet as the ending stock is made up of the most recent purchases.
However, the disadvantage of using FIFO method is that there is a mismatch between the current costs and the current revenues. This is because the oldest costs are considered and are matched with the current revenues. Thus, this can lead to misleading profit figures.
The Last-In-First-Out Method, also referred to as the LIFO Method, is based on the assumption that goods purchased recently are consumed first and the goods purchased first are consumed in the near future.
Therefore, the cost of goods sold under LIFO Method is calculated using the most recent purchases. Whereas the closing stock is calculated using the cost of the oldest units available.
The advantage of using LIFO method of stock valuation is that it matches the most recent costs with the current revenues. Thus, it gives a better measure of profitability.
Furthermore, the LIFO method offers tax benefits to your business. This is because items recently purchased at higher price levels increase the cost of goods sold and reduce the net income. Thus, reduced net income means reduced taxes for your business.
However, the disadvantage of using the LIFO method is that it leads to lower profits for your business when inflation is high.
Reduced earnings further may be misinterpreted by the investors thereby reducing the company’s stock price. Further, the ending stock in the balance sheet recorded at oldest costs understates the working capital position of the company.
The Average Cost Method to value the cost of ending stock takes into consideration the average cost of items available for sale.This means that the units under costs of goods sold and the closing stock are taken at the average cost so calculated.
In case you are using the periodic stock method, the average cost is calculated using the weighted average method. Whereas, in case your business maintains stock records using a perpetual stock method, the average cost is calculated using the moving average method.
This method of stock valuation is widely used as it is simple to use. Also, it is difficult to manipulate net income under this stock pricing method.
To apply the specific identification method of stock valuation, it is necessary that each item sold and each item in closing stock are easily identifiable.
Therefore, such a method is applicable only in cases where it is possible to physically differentiate the various purchases made by your business.
Thus, items sold at a specific cost during the accounting period can be included in the cost of goods sold. And the costs of particular items left or in hand can be included in the closing stock.
Companies manufacturing or handling expensive, easily distinguishable items can successfully use this valuation method. Such items include automobiles, furniture, jewelry etc.
The Receiver of Revenue (SARS) department permits companies to deduct the cost of goods utilised to manufacture or purchase goods that need to be sold to the customers. Thus, the cost of all such goods is covered under Cost of Sales that is showcased as one of the items in the Income Statement.
But not all firms can showcase such a deduction on their income statement. Businesses that offer services like accounting, real estate services, legal services, consulting services, etc instead of goods to their customers cannot showcase COS on their income statement.
This is because such service-oriented businesses do not have any Cost of Sales (COS). In place of COS, such service rendering companies have Cost of Services. Thus, Cost of Services is not the same as COS deduction.
According to Generally Accepted Accounting Principles (GAAP), COS is defined as the cost of stock items sold to customers in a given period of time. Thus, this definition does not talk about any other detail with regards to COS like cost of services.
So, if we consider companies providing services to their clients, such companies neither have goods to sell nor have any inventories. Therefore, in case of service companies, if COS is not reflected in the income statement, then there can be no COS deduction.
In fact, the service-oriented companies just have a Cost of Services that is not the same as COS deduction.
Cost of Revenues is not the same as Cost of Goods Sold. Cost of Revenues includes both the cost of production as well as costs other than production like marketing and distribution costs.
In other words, the cost of revenues takes into consideration:
Thus, the cost of the revenue takes into consideration COGS or Cost of Services and other direct costs of manufacturing the goods or providing services to the customers. Such cost would include costs like cost of material, labour, etc. however, it does not consider indirect costs such as salaries for determining the Cost of Revenue.
Stock Account
To balance c/d
Stock refers to the merchandise that is bought during the year but has not been sold to the customers. Stock on the balance sheet comprises of :
Typically, stock is valued at cost. It is one of the significant items that form part of the current assets of a business entity. You must remember that the per-unit cost of stock changes over time. Hence, you must choose a method of accounting stock such as LIFO, FIFO, average cost, and specific identification so that stock cost can be expensed to COS.
Also, one needs to keep track of stock as less stock could mean losing revenue and customers.
On the other hand, too much stock could pose cash flow challenges as excess cash would be tied to stock. In addition to this, excess stock could also result in additional costs for the business in terms of insurance, storage, and obscene.
The cost of sales, also known as the cost of goods sold (COGS), represents the direct costs related to the manufacturing or purchasing of a good that is sold to a customer. Companies use this measurement to calculate their gross margin.
The cost of sales formula can be calculated two different ways. You can adjust the cost of the goods purchased or manufactured by the change in stock during a given period. You can also add the cost of goods purchased or manufactured to the stock at the beginning of the period and subtract the stock of goods at the end of the period.
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