inventory to cost-of-goods sold (COGS) ratio
the direct costs required to produce a specific good for sale.
Cost-of-Goods Sold Ratio Details
A common figure in financial statements is the cost-of-goods sold; the COGS ratio is removed from a company's profits when calculating gross profit, which is a measure of profitability that assesses a company's efficiency managing the labor and supply demands of its production process.
As COGS is considered a cost of doing business, it is written into income statements as a business expense. Knowledge of it increases the accuracy of bottom-line estimates. The higher the COGS, the lower its net income and amount to be distributed among shareholders.
Because COGS is the cost of creating or developing the product that a company sells, only the costs directly involved in that process - labor, materials, and operational expenses directly tied to production - are included. Excluded from the computation are indirect costs, such as distribution and marketing, and all direct or indirect costs incurred on unsold products.
Below is the formula for calculating COGS:
Cost-of-Goods Sold = Beginning Inventory + Additional Inventory – Ending Inventory.
Beginning inventory is the cost of purchasing or producing the existing inventory at the start of the period.
Additional inventory is the cost of increasing the inventory within the period.
Ending inventory is the cost of the existing inventory by the end of the period.
Before calculating COGS, it is important to decide on adding a cost to the ending inventory. Here are the three most commonly used options:
- FIFO (First In, First Out) - The earlier an item was added to the inventory, the sooner a company should sell it. Because prices go up as time passes, this improves profits and taxes.
- LIFO (Last In, First Out) - The last and often the priciest item included in the inventory is the first item to go, leading to higher COGS and lower profits and taxes.
- Average Cost - No matter when the inventory was produced or purchased, all costs are averaged, hence evening out COGS, profits, and taxes.
Calculating COGS requires specific values, including:
- Purchases - Generally used as the wholesale costs of products for sale, this refers to the total amount a company has spent to produce the inventory.
- Materials - This covers the costs of all materials and supplies used to produce the items for sale. Producers usually count on this to take stock of raw material and assembly costs.
- Labor - This refers to the total costs paid to workers and contractors who directly participated in building the inventory.
- Other Direct Costs - Also included as direct costs are overheads, such as water, power and rent, and all other costs.
Real-World Example of Cost-of-Goods Sold Ratio
Vedder Bikes makes innovative motorcycles from basic purchased components. On its December 23, 2019 balance sheet, its ending inventory cost is the beginning inventory cost for 2020, which is listed at $6.25 million.
Over the year, Vedder Bikes bought $12.5 million worth of supplies. They spent $7.5 million in labor, plus other direct costs that produced $20 million more in added inventory using the average cost method. On December 23, 2019, the ending inventory value was $7 million. What is Vedder Bikes' COGS for 2019?
COGS = Beginning Inventory + Additional Inventory – Ending Inventory
COGS = $6.25 million + $20 million – $7 million
COGS = $19.25 million
If Vedder Bikes made net sales revenues of $30.5 million in 2019:
Gross Profit = Net Sales Revenue – COGS.
Gross Profit = $30.5 million – $19.25 million
Gross Profit = $11.25 million
Returns, loss allowances, and post-sale rebates are deducted from total sales to get the net sales revenue. If Vedder Bikes used the FIFO method, this would have reduced its COGS and maximized its gross profit. The opposite would be true using the LIFO method.
Cost-of-Goods Sold vs. Cost of Sales (COS)
The main distinction between COGS and COS is the absence of indirect costs in calculating COGS, which captures the movements in inventory and current assets and the efficiency of converting inventory into cash.
A second key difference lies in the actual cost represented - COGS reflects the costs of producing the inventory, while COS stands for selling that inventory. Also, it is common knowledge that business performance fluctuates over time, while COGS does not include any unsold items. The COGS metric is ordinarily used in companies directly involved in producing or trading goods and services. However, COGS is a generic term used in accounting, where it is understood as the cost of selling goods and services.
On the other hand, COS is not always uniform across companies and industries, each of which has its own COS definition and processes. In accounting, there are no clear guidelines on which costs may or may not be included in the calculations instead of COGS, which has remained consistent under the Notes to Accounts section of the balance sheet.