What is ‘Cost of Goods Sold’?
Simply put, ‘cost of goods sold’ equals the direct costs of materials, human resources, and equipment needed to produce the item sold. However, this can be confusing because there are many marginal cost items that affect the real cost of producing and selling the item. From the utilities to the facility costs, all of these have a bearing on the final cost to produce the item.
This article is an introduction to the accounting formula used to determine cost of goods sold. If you desire a more in-depth understanding, then please read: Cost of Sales – Various Formats.
So what is and how do you calculate the ‘Cost of Goods Sold’? As not to overwhelm the beginner, let’s agree on the basic elements of the cost associated with the item sold. These basic elements are the materials, labor, and equipment (usually transportation). Naturally, each industry and production process has a bearing on the final calculation.
Let’s start out with a relatively simple transaction, a retail store sale.
Here, the costs would be the original cost of the item sold to the customer. If the widget was X dollars for the original price paid by the store to the wholesaler, then this is the cost. However, often there is more to it. Many times, the retail outlet has to pay for the shipping cost to get it to the store, or even the shipping cost to deliver the product to the customer. So these would be included in the cost of goods sold section of the profit and loss statement. Now let’s complicate this a bit more.
Let’s assume that we have to prep the item to be sold, as an example, we own a lawn equipment retail outlet. The lawnmower is received and we have to assembly the item. Now we have a direct labor cost to prepare the item for sale. This cost is included as labor in the report.
Cost of Goods Sold
Purchase price of lawnmower $Z,ZZZ
Assembly labor ZZ
Delivery cost from manufacturer ZZ
Delivery cost to customer ZZ
Total Cost of Item Sold $Z,ZZZ
If this type of transaction were done several times over in an accounting period such as one month, then you can see how the final dollars are calculated.
If the item sold has more elements involved, you would continue to add more line item costs to further expand the scope of information associated with the items sold. In the auto retail industry, they include such line items as interest on the loan to carry the car on the showroom floor or lot, if the vehicle had upgrades installed then another line item for that service is included. They include maintenance on the vehicles such as cleanings, minor repairs, and sometimes separate insurance associated with that particular unit.
With construction, the cost of the homes sold section looks like this:
Costs of Construction
Land Purchased $ZZZ,ZZZ
Licenses & Permits Z,ZZZ
Direct Insurance ZZ,ZZZ
Commissions Paid (Real Estate Broker) ZZ,ZZZ
Closing Costs ZZ,ZZZ
Total Costs of Homes Sold $Z,ZZZ,ZZZ
Each industry has a different format to report Cost of Goods Sold. In the service based industries, this section is called the Cost of Services Rendered (Provided). The primary element is of course labor, then they would include labor benefits, and other labor costs like employment taxes. Often you’ll also see transportation costs in this section as the labor provides services at remote sites. A good example of this format is a medical office providing the service of labor and they provide medicinal products too. Here is an example of Costs of Services Rendered (Provided) section of the Profit and Loss Statement:
Cost of Services Provided
Medical Professionals (Dr’s., RNs) $ZZZ,ZZZ
Labor Burden (Benefits, Taxes, etc.) ZZ,ZZZ
Medicinal Supplies Z,ZZZ
Labor Insurance Z,ZZZ
Total Cost of Services Provided $ZZZ,ZZZ
Note that this section relates to the direct service of providing the medical care to the patients. If the office had an equipment intensive delivery of service, there would be a line item for medical equipment too.
The key to understanding Cost of Goods Sold is that we include those costs that can directly connect to the item sold or service provided. But it gets more complicated when you begin to include items such as utilities and facility costs when producing items for sale in manufacturing. There that industry uses several other types of costs grouped into the ‘Cost of Goods Sold/Produced’ section of the Profit and Loss statement. This will be addressed in another article. For the small business entrepreneur, include those costs that you directly associate with the product sold. This is generally materials, labor, and transportation costs. As you learn more, you’ll become not only better able to understand your own financial reports, but the reports of others. Act on Knowledge.
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