Both cost of goods sold (COGS) and net sales, which require knowing the cost of sales to calculate, are key lines on your small business’s income statement. COGS and cost of sales both help to determine your company’s profits and efficiency in creating products and services. Though these metrics sound similar – and are similarly important for a small business – the cost of sales definition is ever so slightly different from the definition for COGS.
Cost of sales definition
Financial experts define the cost of sales as the direct and indirect costs your small business incurs to sell its products or services. Cost of sales accounting relies on the following formula:
cost of finished goods in your beginning inventory
+ cost of goods created during your accounting period
- cost of finished goods in your ending inventory
= cost of sales
As a cost of sales example, pretend that your small business has spent $1,000 on the finished goods in your beginning inventory and spent another $2,000 on creating goods during your current accounting period. If your ending inventory has a goods cost of $1,500, then your cost of sales is $1,000 + $2,000 - $1,500 = $1,500.
Cost of goods sold (COGS) definition
The cost of goods sold (COGS) defines all expenses your small business incurs to create and offer its products and services. Examples of cost of goods sold expenses are direct labor, overhead, materials, storage, and the wholesale price of products resold elsewhere.
A cost of goods sold example expense might be the purchase of metals that your small business uses in its electronic products, the rent your small business pays for its office, or the payments your small business makes to its employees for their work. Note that, when distinguishing COGS vs. an expense, the former relates only to sales, whereas the latter could refer to all business operations.
What is included in the cost of goods sold?
As mentioned at above, the cost of goods sold includes:
- Direct labor
- Overhead expenses such as office rent
- Raw materials
- All supplies and parts used to create the product or service
- The wholesale price of any goods or services you resell
- Containers and storage
Why the cost of sales and COGS matter
Cost of sales and COGS matter since they reflect the operating expenses behind your production methods. The cost of sales also shows how much money you’re putting into your sales. Additionally, when you subtract the cost of sales from your sales revenue, you’re left with your gross profit.
When you compare the values of each metric to your revenue, you’ll better understand fluctuations in your bottom line. For example, if your cost of goods sold increases as your revenue decreases, you’ll know your input costs are increasing. You might then determine that there is justification in raising your prices to account for this shift. Your revenue might then increase in tandem.
When to use the cost of sales or COGS
If your company is a service provider or retailer, you should use the cost of sales. (Some companies like these use the “cost of revenue” instead.) If your small business manufactures tangible products, you should use COGS. And if your company does both – say, a massage parlor that sells skincare goods – you can use both. You’ll categorize your massage expenses via cost of sales and your skincare goods expenses via COGS.
8 key differences between the cost of sales and COGS
Although many people use the cost of sales and COGS interchangeably, there are 8 key differences between the two terms. These differences should elucidate that, though using the cost of sales and COGS interchangeably is somewhat common practice, doing so can be misleading. If anything, using one value in place of the other may actually deceive you if thinking your processes are working well and they’re actually needing improvement. Here’s why.
1. Direct vs. indirect costs
The cost of sales includes the direct and indirect costs your small business incurs when selling products or services. COGS refers to the direct costs of solely the production of products or services.
2. Income statement placement
COGS on an income statement appears after your small business’s revenue. The cost of sales appears before the operating margin.
3. Breadth of terms
The cost of sales encompasses far more than COGS does. The cost of sales assesses your small business’s entire inventory, whereas COGS looks solely at your production costs.
4. Tax deductibility
While COGS and cost of sales are sometimes seen as synonymous terms, conflating the two can cause further issues come tax time. That’s because COGS is tax-deductible, whereas the cost of sales is not.
5. Calculation methods
To calculate COGS, you must know the total amount of products or services that your business creates during an accounting period. The cost of sales, on the other hand, reflects the total amount of products or services that are not just created but successfully sold.
6. Never the same value
Since the cost of sales factors in additional costs to those included in COGS, the cost of sales will always be greater than COGS. These additional costs pertain to what you must do with your products after you create them to ensure they’re actually sold.
7. Sales vs. manufacturing
The cost of sales indicates how much money goes into selling products that you’ve already manufactured. COGS indicates solely the cost of your manufacturing whether or not the goods are sold. This distinction is also why the cost of sales is always higher than COGS. You can’t just manufacture something and expect it to move units – you need to spend extra money on marketing.
8. Use cases
Retailers and service providers should use the cost of sales on their income statements. Manufacturers should use COGS. A company that provides both services and tangible products can use the cost of sales for the former and COGS for the latter.
6 things you must know to calculate COGS
To calculate COGS, you need to have the following information:
1. Valuation method
Your COGS will depend on which valuation method you use for your inventory. You have three choices:
- First in, first out (FIFO). Using FIFO, your small business will first sell the products or services it has created the earliest. When the FIFO method is used, a lower COGS value may result since product and service prices tend to increase with time.
- Last in, first out (LIFO). LIFO is the opposite of FIFO: The products or services created most recently are sold first. Since the prices of these items may be higher, a larger COGS value may result.
- Average cost method. In the average cost method, the age of products and services is irrelevant. Instead, the average price of all products and services in stock determines the value of COGS.
2. Beginning inventory
Your beginning inventory includes:
- All merchandise you keep in stock
- Raw materials
- Products and services in progress
- Finished products and services
- Additional supplies provided with your goods and services
Note that your beginning inventory at the start of a tax year must be exactly the same as your ending inventory for the prior tax year. If they are not the same, you will need to file a written explanation to the IRS along with your annual tax forms.
3. Cost of labor
To determine the cost of labor for your tax year, add together all payments to employees involved in creating your products or services. Exclude payments to employees who only sell your products or services; their work is factored into your cost of sales accounting, not COGS.
4. Cost of purchases, materials, and supplies
Any purchases, materials, and supplies you must make to create your products or services should be included in your COGS calculations. COGS on your income statement will reflect all expenses, including these purchases, involved in your business’s production operations.
5. Other costs
Any other costs associated with creating your products or services, such as rent for the office or laboratory space in which your services are offered, or your products are created, should be included in your COGS calculations.
6. Ending inventory
You can determine your ending inventory costs by taking a physical inventory, or at least an estimate, of your products and services. Then, as with your cost of sales calculations, to determine COGS, you should subtract the costs of your ending inventory from the labor, purchases, materials, supplies, and other costs you have added to your beginning inventory.
You should notice that your COGS value will differ significantly from your cost of sales value. That’s how you’ll know you’ve properly calculated both these vital business metrics and are on your way to a thorough, accurate income statement.
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