Any business needs to know about Cost of Goods Sold (COGS), but accrual accounting users need to know even more. COGS stands for the straight costs that a company has to pay to make the things it sells. This metric is necessary to figure out gross profit and get a sense of the company's general financial health. This piece will explain what COGS is, how it works with accrual accounting, and why it's important for your business.
What is the Cost of Goods Sold (COGS)?
The direct prices that a company has to pay to make the goods it sells are called "cost of goods sold" (COGS). This includes things like
Raw materials
Labor costs directly associated with production
Manufacturing overhead
Direct costs, like promotion and sales costs, are not included in COGS because they belong to a different category. To find your business's gross earnings, which is found by applying the following formula:
Gross Profit = Revenue - COG
Why is COGS Important?
Profitability Analysis: Cost of goods sold (COGS) has a direct effect on your gross profit margin. A lower cost of goods sold (COGS) means better profits, which is important for a business to stay in business.
Tax Implications: Cost of goods sold (COGS) is a deductible cost, which means it can lower your taxable income. Knowing your COGS can help you make the best tax decisions.
Inventory Management: Keeping track of inventory Businesses can better control their inventory levels with COGS, making sure they don't make too many or too few things.
Read More: Inventory vs Cost of Goods Sold
How COGS Works in Accrual Accounting
With accrual accounting, income and costs are recorded as they happen, not when the cash deals take place. This way gives a more accurate picture of how well a business is doing financially. In terms of COGS, this means that costs related to making goods are tracked when the goods are sold, not when the cash is received.
COGS Calculation in Accrual Accounting
To calculate COGS, you can use the following formula:
COGS = Beginning Inventory + Purchases - Ending Inventory
Beginning Inventory:Â The value of inventory at the start of the accounting period.
Purchases: The total cost of inventory purchased during the period.
Ending Inventory: The value of inventory remaining at the end of the period.
Example of COGS Calculation
Let’s say your business has the following data for the year:
Beginning Inventory: $10,000
Purchases: $50,000
Ending Inventory: $15,000
Using the formula:
COGS = $10,000 + $50,000 - $15,000 = $45,000
This means that your COGS for the year is $45,000.
Best Practices for Managing COGS
1. Implement Inventory Management Software
Inventory management tools can make it easier to keep track of how much inventory you have, what you buy, and what you sell. This software can automatically figure out your cost of goods sold, which lowers the chance of making a mistake and gives you real-time information about the state of your inventory.
2. Regularly Review Your COGS
Make it a habit to look over your COGS often. This can help you spot trends, like rising costs of materials or production that isn't working as well as it could. You can also change your pricing plan to keep making money by reviewing it often.
3. Train Your Team
Make sure everyone on your team knows how important it is to keep correct records of inventory and calculate COGS. Giving people training on the best ways to do things can help them enter and handle data better, which will improve your financial reporting in the long run.
4. Conduct Periodic Audits
Checking your inventory and cost of goods sold (COGS) on a regular basis can help you find mistakes and make sure your financial records are correct. This can also help you find places where you can save money.
5. Collaborate with Your Accountant
Make sure that your COGS is shown correctly in your financial records by working closely with your accountant. They can help you plan for future growth and give you useful information about how COGS affects your total financial health.
Read More: Operating Expenses vs Cost of Goods Sold
Common Questions About COGS
How Does COGS Affect Financial Statements?
On the income statement, COGS is shown. To find gross profit, take total sales and subtract COGS. A bigger COGS can mean that production isn't working as well as it should or that the cost of materials has gone up, while a lower COGS can mean that costs are being managed better.
What is the Difference Between Direct and Indirect Costs?
Direct Costs: These are costs that can be directly attributed to the production of goods, such as raw materials and labor.
Indirect Costs: These are costs that cannot be directly linked to production, such as administrative expenses and marketing costs.
How Can I Reduce COGS?
Reducing COGS can significantly improve your profit margins. Here are some strategies:
Negotiate with Suppliers: Seek better pricing or bulk discounts from your suppliers.
Improve Production Efficiency: Streamline your production processes to reduce waste and labor costs.
Optimize Inventory Management: Use inventory management software to track stock levels and avoid overproduction.
Conclusion
Understanding the Cost of Goods Sold (COGS) in the context of accrual accounting is essential for any business looking to improve its financial health. By accurately calculating and managing COGS, you can gain insights into your profitability, optimize your inventory management, and make informed financial decisions.
If keeping track of your COGS and books is too much for you, you might want to work with a professional bookkeeping service like Irvine Bookkeeping. Our team's main job is to help small and medium-sized businesses improve their financial processes. This makes sure that everything is done correctly and saves you time.
The Role of Bookkeeping in Managing COGS
Bookkeeping is an important part of having accurate COGS records. For accurate financial reporting, it's important to make sure that all costs are recorded properly, which is what good bookkeeping does.
