The Statement of Profit or Loss is one of the main financial statements that businesses prepare. It contains exclusive information that other financial statements do no show. The statement is a combination of the revenues of a business, and its expenses.
One of these expenses and an important part of any Statement of Profit or Loss is the Cost Of Goods Sold (COGS).
The Cost Of Goods Sold consists of all the expenses that businesses incur on the production or purchase of goods they sell. COGS mainly applies to businesses that deal in inventories whether purchased, for instance, retailers, or produced, for instance, manufacturing businesses.
As the name suggests, the Cost Of Goods Sold only relates to goods that a business sells to its customers. However, for service-based businesses, the Cost Of Goods Sold maybe a little bit different as usually there is no physical inventory for them.
Before service-based businesses can understand how to calculate COGS for them, it is important to know what COGS is.
What is the Cost of Goods Sold?
As mentioned above, Cost Of Goods Sold is all the costs of a business that relate to the products it sells, whether manufactured or purchased. However, essentially, the COGS comprises of all the direct costs of a business that it incurs on its goods sold.
Direct costs consist of material and labor costs that directly attribute to the costs of products. It does not consist of indirect costs of a business such as marketing and selling expenses. Indirect costs do not attribute to the cost of a product.
The COGS is a variable cost for businesses. That means the higher the number of products a business sells, the more its COGS will be. On the other hand, if a business does not sell any products, it will have no COGS. The COGS of a business depends on its number of products sold.
That is different from other types of expenses that a business incurs regardless of whether it makes any sales or not. For example, a business has to pay rent regardless of its number of products sold.
In the context of service-based businesses, COGS includes all the goods that are necessary for the sale of services.
Similarly, since COGS only consists of direct costs, the COGS for a business will also consider only goods that are directly related to the provision of services. Any costs borne on goods that do not directly relate to the provision of services are not a part of COGS.
Cost of Goods Sold for Service
Sometimes, businesses may also have Cost Of Goods Sold for service. For example, when a service-based business charges for the items it uses in the provision of service to the clients, then it must also calculate the Cost Of Goods Sold.
These instances are rare as most businesses already account for the cost of goods that they use in the provision of services in the price of their service. However, some businesses work on a job system with clients, where clients agree to pay all expenses and a predetermined profit percentage to the business.
In those cases, Cost Of Goods Sold may directly be a part of the services provided.
One example of a service-based business that also sells goods is a gym, which is a type of service-based business but may also sell supplements considered as goods rather than services.
Similarly, a hospital that provides service in the form of treatment to the patient also sells medicines to patients considered goods rather than services. Practically, there are also many other examples of service-based businesses that may also deal with goods.
Calculating Cost Of Goods Sold
The calculation of Cost Of Goods Sold is straightforward whether for service-based business or other business.
The calculation involves adding the opening balance of inventory and the total purchases of the business and subtracting the closing balance of inventory from it. The formula for COGS is as below:
Cost Of Goods Sold = Opening Inventory + Purchases – Closing Inventory
For example, a service-based business charges the goods it uses to its clients. The business had a closing inventory of $1,000 in the previous period, which is the opening inventory for the current period. It purchased further goods worth $2,000 during the period.
It’s closing balance for goods at the end of the period was $500. Therefore, the Cost Of Goods Sold for the business will be $2,500 ($1,000 + $2,000 – $500). The business can charge the Cost Of Goods Sold in its financial statements.
The Cost Of Goods sold is an important item in the Statement of Profit or Loss of any business. It is particularly crucial for businesses that deal with inventories or goods.
However, sometimes it may also apply to service-based businesses. COGS mainly consist of direct costs.
Therefore, for service-based businesses, it will also consist of goods that they use directly in the provision of their services. Businesses, whether dealing in goods or services, can calculate COGS using the same formula.