Importance of Cost of Goods Sold (COGS)
The Cost of Goods Sold plays a significant role in determining a business’s financial performance. Below are the key reasons why COGS is important:
- Gross profit calculation: COGS is subtracted from revenue to determine the gross profit, indicating a business’s profitability
- Pricing strategy: Understanding COGS helps businesses set competitive prices while ensuring sufficient profit margins
- Financial planning: It aids in budgeting and forecasting by providing insights into production costs
- Tax benefits: COGS can be deducted from taxable income, reducing overall tax liabilities
- Operational efficiency: Analysing COGS helps identify cost-saving opportunities and improve operational processes
What does the Cost of Goods Sold (COGS) include?
COGS includes all direct expenses involved in manufacturing a product or delivering a service. These can be grouped into the categories below:
Cost Category
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Description
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India-Specific Examples and Considerations
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Raw Materials
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Costs incurred in procuring materials required for production.
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Purchase of steel for fabrication units, or cotton for textile manufacturing.
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Direct Labour
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Wages paid to workers directly engaged in the production process.
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Salaries of assembly line workers, excluding administrative or managerial staff.
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Factory Overheads
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Indirect expenses linked to operating the production facility.
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Electricity and water used on the factory floor, depreciation on manufacturing equipment.
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Freight-In Costs
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Transport expenses incurred to bring raw materials to the production site.
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Freight charges on domestic procurement or import duties on imported inputs.
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Packaging Costs
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Costs of materials used for packaging finished goods.
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Product-specific packing required before dispatch or sale.
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GST Input Tax Credit (ITC)
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Net cost after adjusting eligible GST paid on inputs directly used in manufacturing.
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ITC claimed on raw materials and production-related services, reducing the effective purchase cost for COGS.
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Different accounting methods for COGS
Since inventory costs fluctuate over time, different valuation methods are used to determine which cost is applied to the goods sold.
- First-In, First-Out (FIFO): Assumes the earliest purchased inventory is sold first. In periods of rising prices, this usually leads to a lower COGS and higher reported profit. For example, a pharmaceutical distributor may use FIFO so that older batches of medicines are cleared before expiry.
- Last-In, First-Out (LIFO): Assumes the most recently purchased inventory is sold first. This results in a higher COGS and lower profit when prices are increasing. However, LIFO is not permitted under Indian Accounting Standards (Ind AS) or IFRS.
- Weighted Average Cost (WAC): Determines the average cost of all units available for sale during the period. This method helps smooth out price fluctuations. For instance, cement manufacturers dealing with uniform, high-volume materials commonly use the WAC approach.
- Specific Identification: Assigns the actual cost of each item sold. This method is used for unique, high-value items. For example, a jeweller records the specific purchase cost of each diamond or gold ornament.
Formula of Cost of Goods Sold (COGS)
The formula for calculating COGS is straightforward and essential for financial analysis. Below is the step-by-step process:
- Opening inventory: Determine the value of inventory at the beginning of the period
- Add purchases: Include all purchases made during the period for production
- Subtract closing inventory: Deduct the value of unsold inventory at the end of the period
- COGS formula: Opening Inventory + Purchases - Closing Inventory
This formula provides a clear picture of the direct costs associated with production.
How to calculate the cost of goods sold (COGS)?
Accurate calculation of COGS is vital for financial management. Follow these steps to calculate COGS:
- Determine opening inventory: Assess the value of inventory at the start of the period
- Add direct costs: Include raw materials, labour, and overheads incurred during production
- Account for purchases: Sum up all additional purchases made during the period
- Calculate closing inventory: Value the remaining inventory at the end of the period
- Apply COGS formula: Subtract the closing inventory from the total of opening inventory and purchases
Calculation with example
To understand COGS better, let us consider a practical example:
Scenario 1: Retail Business (Buying and Selling Goods)
Item
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Amount (₹)
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Opening Inventory (1st April)
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80,000
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Purchases During the Year
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5,50,000
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Closing Inventory (31st March)
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1,20,000
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COGS
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₹80,000 + ₹5,50,000 - ₹1,20,000 = ₹5,10,000
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Scenario 2: Manufacturing Business (Calculating Cost of Goods Manufactured - COGM)
In manufacturing, COGS calculation is slightly more complex as it first requires calculating the Cost of Goods Manufactured (COGM).
Item
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Amount (₹)
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Opening Work-in-Progress (WIP)
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1,00,000
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Raw Material Used
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2,50,000
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Direct Labour
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1,50,000
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Manufacturing Overheads
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50,000
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Total Manufacturing Cost
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4,50,000
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Less: Closing WIP
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-50,000
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COGM (Cost of goods completed)
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₹5,00,000
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Opening Finished Goods Inventory
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1,50,000
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Closing Finished Goods Inventory
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(1,00,000)
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COGS
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₹5,00,000 + ₹1,50,000 - ₹1,00,000 = ₹5,50,000
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Common mistakes in calculating COGS and how to avoid
Common Mistake
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Impact
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How to Avoid
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Misclassifying expenses
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Adding indirect costs such as rent, marketing, or administrative salaries into COGS, which artificially inflates expenses and reduces gross profit.
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Maintain separate accounts for Direct Costs (COGS) and Operating Expenses (OpEx). Check whether a cost is directly required to produce the product.
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Ignoring or estimating inventory
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Incorrect physical counts or failing to match opening and closing inventory leads to distorted COGS figures.
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Carry out regular physical inventory audits monthly or quarterly. Ensure the closing inventory of one period becomes the opening inventory of the next.
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GST treatment errors
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Recording the full GST paid on inputs instead of the net amount after claiming Input Tax Credit (ITC), leading to overstated costs.
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Always compute COGS using the purchase cost excluding eligible GST, after applying ITC.
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Inconsistent valuation method
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Switching between FIFO, WAC, and other methods to influence profit levels results in non-compliance and unreliable reporting.
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Select a valuation method suitable for your business and apply it consistently across accounting periods.
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Ignoring direct costs
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Overlooking essential direct expenses such as freight-in charges, import duties, or packaging affects true cost measurement.
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Record and track every expense required to bring inventory to your warehouse and into a saleable condition
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Type of companies excluded from a COGS deduction
Certain businesses cannot claim a deduction for COGS due to the nature of their operations. These include:
- Service-oriented businesses: Companies that provide services instead of physical products, such as consulting firms
- Financial institutions: Banks and investment firms where direct production costs are not applicable
- Non-profits: Organisations not engaged in profit-making activities
- Educational institutions: Schools and universities where services are rendered rather than goods sold
- Government agencies: Public sector organisations focused on governance and public welfare
What are the limitations of COGS?
While COGS is a vital metric, it has certain limitations, particularly for small Indian businesses:
- Excludes indirect costs: COGS accounts only for direct production expenses and leaves out key overheads such as marketing, administrative salaries, rent, and head-office utilities, all of which influence overall profitability.
- Prone to manipulation: Businesses may overstate or understate inventory levels to alter COGS and gross profit for tax or reporting advantages.
- Complex inventory tracking: Accurate valuation requires detailed records, which can be difficult for MSMEs that rely on informal bookkeeping. Errors in inventory counts can lead to misleading COGS figures.
- Method-based variations: The chosen inventory valuation method (FIFO, WAC) can materially impact the COGS value and the profit reported.
How COGS affects tax planning and financial reporting
COGS is more than a routine expense. It plays a central role in financial management:
- Tax planning: A higher but correctly computed COGS reduces Gross Profit and therefore lowers taxable income. This is a legitimate tax-minimisation approach, provided all supporting costs are accurately recorded and verifiable under the Income Tax Act.
- Financial reporting and compliance: Accurate presentation of COGS in the Profit and Loss Statement is mandatory under Indian Accounting Standards (Ind AS) and for Income Tax compliance. Errors or deliberate misstatements can trigger audits and attract penalties.
- Lender confidence: Banks and financial institutions, including Bajaj Finance, closely examine Gross Margin (Gross Profit divided by Net Sales) to evaluate business health. A well-controlled COGS signals operational efficiency and strengthens the chances of obtaining finance, such as a business loan.
Differences between COGS, OpEx and Cost of Revenue
Feature
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Cost of Goods Sold (COGS)
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Operating Expenses (OpEx)
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Cost of Revenue (COR)
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Definition
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Represents the direct costs incurred to produce goods or deliver services sold by the business.
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Covers the indirect costs required to run and manage day-to-day business operations.
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Includes all costs directly linked to generating revenue and is broader in scope than COGS.
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Scope
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Focused on production and inventory-related expenditure.
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Relates to general business functions such as selling, administration, and support activities.
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Includes COGS along with other direct revenue-generating expenses such as distribution.
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Examples
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Raw materials, direct labour, and utilities used in production.
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Office rent, marketing and administrative salaries, and professional fees.
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For service companies: direct employee costs, hosting expenses, and distribution-related costs.
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Financial Impact
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Used to calculate Gross Profit.
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Used to determine Operating Profit (EBIT).
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Applied by both product and service businesses to arrive at gross margin.
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Conclusion
Understanding the Cost of Goods Sold (COGS) is crucial for businesses aiming to improve their financial performance. COGS directly impacts revenue, income, and overall profitability. By accurately calculating COGS, businesses can make informed decisions about pricing, budgeting, and cost optimisation. Additionally, understanding the differences between COGS, operating expenses, and cost of revenue is vital for comprehensive financial analysis. For businesses seeking to manage their working capital effectively, considering options like a business loan through Bajaj Finance can provide valuable financial support.
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