Cost of goods sold also referred to as the cost of sales is the cost you incur to make your products or services. Generally, this cost includes direct material, direct labor, and production overheads.
In a service business, this cost will include the pay of labor, taxes paid, and any benefit given to people who are involved in the sales.
However, in a merchandising business, it will include the costs incurred and the amount paid to acquire the merchandise from the manufacturer.
The cost of goods sold doesn’t include direct expenses such as sales commission and distribution costs. If you want to know how much is the cost of goods sold incurred by the company during the period, you can just look at the income statement of that period. It is reported right after the revenue.
COGS= Opening Inventory + Purchases made during the period – Closing Inventory
The cost of goods sold is treated as an expense, therefore, it is subtracted from the Sales to find out the gross profit.
Finding out the gross profit is important since it evaluates how efficiently the company is using its labor and supplies in the production process.
Calculating the cost of good sold help analysts, investors, and managers of the company in estimating the company’s profitability. If the Cost of goods sold increases, net income will decrease.
Even though less net income means less tax to be paid, it will also mean fewer funds to distribute to the shareholders. Therefore, businesses try to keep their COGS low in order to have a higher net income.
ven though less net income means less tax to be paid, it will also mean fewer funds to distribute to the shareholders. Therefore, businesses try to keep their COGS low in order to have a higher net income.
How to increase or decrease the cost of goods sold?
There are many ways you can impact the cost of sales. We will enlist some of them down:
- Cash discount: If a company starts bulk buying their materials, it will affect the Cost of Goods Sold. When buying in larger quantities from the same supplier, the supplier will offer quantity based discounts and decrease the COGS.
- Shipping discount: There may also be shipping discounts involved as more material means less per unit cost and fewer COGS.
- Changing supplier: Another way to decrease the Cost of Goods Sold can be to substitute some materials for lower-cost materials. Technology is constantly improving, and it’s easier to pay less for something and have the quality still be the same. However, it’s important to think about all factors when switching to a lower-priced material. For example, substituting materials may result in the actual product being of inferior quality.
- Increase in labor cost: Using different materials, however, may lead to changing some ways of production, for example, increasing the workload per machine, and this may, in turn, increase costs like direct labor, which may result in higher COGS.
- Increase efficiency: It may also be better not to substitute the material at all – instead, use better machinery, so less material is used with the least amount of wastage and higher production. Better machinery will lead to improved efficiency and fewer COGS.
- Quality over quantity: It’s also very crucial to research how many suppliers are offering the same materials for different prices. Find out which supplier delivers quickly, offers more discounts, has lower shipping costs, and overall is a better supplier to deal with. It’s okay to pay more for the materials if the supplier’s service is better, even if the COGS are increased.
- Labour automation: Although labor is the one operating the machinery, it’s effective to replace any labor with machinery if possible. Having labor is sometimes a hassle as laborers form unions go on strikes if they are being paid less, which may increase your COGS due to paying high wages to direct labor.
- Warehouse: Material storage is also another thing that has an impact on COGS. Finding a good storage place or warehouse is important and should be thoroughly researched since higher holding costs increase COGS, and lower holding costs decrease COGS.
There are lots of ways are available to increase or decrease COGS. It all depends on what strategies the company chooses to employ.