Cost of goods sold (COGS), referred to as cost of sales in UK statutory accounts, is the total direct cost incurred in producing or purchasing the goods that a business has sold during the accounting period. It appears on the income statement immediately below turnover, and the difference between the two gives the gross profit.
Under the Companies Act 2006 profit and loss account formats, cost of sales is a required line item when a company presents its accounts using the function of expense format (Format 1).
How to Calculate Cost of Goods Sold
The standard formula adjusts purchases for changes in stock levels:
COGS = Opening Stock + Purchases - Closing Stock
Worked Example
A retailer has the following figures for the year:
| Item | £ |
|---|---|
| Opening stock (1 January) | 45,000 |
| Purchases during the year | 230,000 |
| Closing stock (31 December) | 38,000 |
| Cost of goods sold | 237,000 |
If turnover for the year is £400,000, gross profit is £163,000.
What Is Included in COGS?
COGS captures the direct costs attributable to the goods or services sold:
| Included | Not Included |
|---|---|
| Purchase price of goods for resale | Office rent and utilities |
| Raw materials and components | Marketing and advertising |
| Direct production labour | Administrative salaries |
| Factory rent and utilities | Selling and distribution costs |
| Depreciation of production equipment | Depreciation of office equipment |
| Packaging and labelling | Interest payable |
| Freight inwards (carriage inwards) | Research and development |
| Subcontractor costs for production | Bad debts |
The classification matters because costs included in COGS reduce gross profit, while overheads reduce operating profit. Misclassifying costs distorts both margins.
COGS for Different Business Types
Retailers and Wholesalers
For businesses that buy and resell goods without transformation, COGS is relatively straightforward:
COGS = Opening Stock + Net Purchases - Closing Stock
Net purchases means the invoice cost of goods, plus freight inwards, minus returns to suppliers and trade discounts received.
Manufacturers
For manufacturers, COGS includes the full production cost of finished goods:
| Component | £ |
|---|---|
| Opening raw materials | 20,000 |
| Purchases of raw materials | 150,000 |
| Less: closing raw materials | (18,000) |
| Raw materials consumed | 152,000 |
| Direct labour | 80,000 |
| Factory overheads | 45,000 |
| Total production cost | 277,000 |
| Opening finished goods | 30,000 |
| Less: closing finished goods | (35,000) |
| Cost of goods sold | 272,000 |
Service Businesses
Service businesses use cost of sales rather than COGS. This typically includes:
- Direct staff costs (salaries of those delivering the service)
- Direct materials used in service delivery
- Subcontractor costs
- Travel costs directly attributable to client engagements
Stock Valuation Methods
The method used to value stock directly affects COGS and therefore gross profit:
FIFO (First In, First Out)
Under FIFO, the oldest stock is assumed to be sold first. In periods of rising prices, FIFO produces lower COGS and higher gross profit because the cheaper, earlier purchases are matched against sales.
Weighted Average Cost
The average cost per unit is recalculated after each purchase. COGS reflects the blended average, producing results between FIFO and the prices of recent purchases.
Which Method to Use
FRS 102 (Section 13) permits FIFO and weighted average cost. It does not permit LIFO (Last In, First Out). The method chosen must be applied consistently. Changing the method is a change in accounting policy and requires retrospective restatement.
| Method | Effect on COGS (Rising Prices) | Effect on Gross Profit |
|---|---|---|
| FIFO | Lower | Higher |
| Weighted average | Middle | Middle |
COGS and the Balance Sheet
COGS is directly connected to stock on the balance sheet:
- Closing stock appears as a current asset
- Opening stock was last year’s closing stock
- The movement between opening and closing stock adjusts purchases to arrive at COGS
Under FRS 102, stock must be valued at the lower of cost and estimated selling price less costs to complete and sell (net realisable value). Writing stock down to net realisable value increases COGS for the period.
Recording COGS: Journal Entries
Purchasing Goods
When goods are received from a supplier:
| Account | Debit (£) | Credit (£) |
|---|---|---|
| Purchases | 10,000 | |
| Accounts payable | 10,000 |
Year-End Stock Adjustment
At year end, the stock account is adjusted and the cost of sales is calculated. Using the periodic inventory system:
| Account | Debit (£) | Credit (£) |
|---|---|---|
| Cost of goods sold | 237,000 | |
| Opening stock | 45,000 | |
| Purchases | 230,000 | |
| Closing stock | 38,000 |
Stock Write-Down
If closing stock includes items where net realisable value is below cost:
| Account | Debit (£) | Credit (£) |
|---|---|---|
| Cost of goods sold (stock write-down) | 3,000 | |
| Stock | 3,000 |
COGS and Corporation Tax
For corporation tax, HMRC uses the accounting figure for cost of sales as the starting point. Specific tax points:
- Stock valuation must follow acceptable accounting practice; HMRC will challenge valuations that appear artificially low
- Work in progress must include an appropriate allocation of production overheads
- Long-term contracts must use the percentage of completion method, recognising profit as work progresses
- Obsolete stock provisions are allowable if based on a genuine assessment of net realisable value
COGS and Gross Profit Margin
The relationship between COGS and turnover determines the gross profit margin:
Gross Profit Margin = (Turnover - COGS) / Turnover x 100
| Year | Turnover (£) | COGS (£) | Gross Profit (£) | Margin |
|---|---|---|---|---|
| Year 1 | 400,000 | 237,000 | 163,000 | 40.8% |
| Year 2 | 450,000 | 280,000 | 170,000 | 37.8% |
| Year 3 | 500,000 | 295,000 | 205,000 | 41.0% |
A declining margin (Year 2) warrants investigation: are purchase prices rising, is the product mix shifting, or are there stock losses?
Reducing COGS
| Strategy | How It Works |
|---|---|
| Supplier negotiation | Securing better prices through volume commitments or alternative sourcing |
| Waste reduction | Minimising spoilage, defects, and scrap in production |
| Stock management | Reducing carrying costs and obsolescence through just-in-time purchasing |
| Process improvement | Automating production steps to reduce direct labour costs |
| Quality control | Preventing defective goods from consuming materials and labour |
| Freight optimisation | Consolidating deliveries and negotiating better shipping rates |
Common Errors in COGS Calculation
| Error | Impact |
|---|---|
| Incorrect stock count (overstated closing stock) | Understates COGS, overstates gross profit |
| Incorrect stock count (understated closing stock) | Overstates COGS, understates gross profit |
| Including overhead expenses in COGS | Understates gross profit, overstates gross margin analysis |
| Omitting freight inwards | Understates COGS |
| Not writing down slow-moving stock | Understates COGS and overstates stock on the balance sheet |
| Inconsistent valuation method between periods | Makes year-on-year comparisons unreliable |
Accurate stock-taking and consistent application of valuation policies are essential. Variances should be investigated as part of the trial balance review process.
COGS and Break-Even Analysis
COGS contains both fixed and variable elements. For break-even analysis, separating the two is essential:
- Variable COGS (raw materials, piece-rate labour) changes with output
- Fixed COGS (factory rent, salaried supervisors) stays constant within a production range
Only the variable portion contributes to the contribution margin used in break-even calculations.