Whether you’re launching a start-up or running a growing small business, understanding your Cost of Goods Sold (COGS) is essential. Far from being just an accounting term, COGS plays a vital role in managing profitability, setting prices, and making strategic decisions.
In this article, we’ll break down what COGS is, how it’s calculated, and why it’s important for your business here in the UK.
1. What is Cost of Goods Sold (COGS)?
COGS refers to the direct costs incurred in producing the goods your business sells. These typically include raw materials, direct labour, and manufacturing overheads directly tied to production.
Put simply, if a cost is directly related to making a product, it falls under COGS. If not, it’s considered a general operating expense.
Example:
If you run an artisan bakery, ingredients like flour, sugar, and butter would be included in COGS. However, expenses like shop rent, insurance, or website hosting would not—they’re considered general overheads.
COGS is crucial for understanding how much it costs to produce the goods you sell. It impacts your gross profit and gives insights into your operational efficiency.
2. What Costs Are Included in COGS?
COGS will vary depending on the nature of your business, but commonly includes:
- Materials: The raw ingredients or components used to produce your products (e.g. timber for furniture or fabric for clothing).
- Direct Labour: Wages paid to employees directly involved in production (e.g. machinists, bakers, assembly workers).
- Production Overheads: Utilities, equipment depreciation, and other indirect costs required to keep production running.
💡 Note: Administrative costs, marketing spend, and general office expenses are not part of COGS.
3. How to Calculate COGS
The formula to calculate COGS is fairly straightforward:
COGS = Opening Stock + Purchases – Closing Stock
Let’s break it down:
- Opening Stock: The value of inventory at the start of the accounting period.
- Purchases: Costs for additional inventory or raw materials bought during the period.
- Closing Stock: The value of unsold stock at the end of the period.
Example:
Suppose you run a gift shop and:
- Opening stock = £4,000
- Purchases during the year = £7,500
- Closing stock = £2,000
Your COGS would be:
£4,000 + £7,500 – £2,000 = £9,500
This figure represents the total cost of the goods sold during that financial period.
4. COGS and Inventory Valuation Methods
How you value inventory affects how you calculate COGS. Here are the most common methods:
- First-in, First-out (FIFO): Assumes the oldest inventory is sold first. Often used in the UK, especially in periods of inflation, as it results in lower COGS and higher reported profits.
- Last-in, First-out (LIFO): Assumes the newest inventory is sold first. Note: This method is not permitted under UK GAAP or IFRS.
- Weighted Average Cost (WAC): Averages the cost of all inventory items, ideal for businesses with interchangeable stock.
✅ Tip: Speak with your accountant to ensure you’re using the appropriate method for your business and reporting requirements.
5. Why Is COGS So Important?
Understanding your COGS offers several key advantages:
- Profit Analysis: COGS allows you to calculate your gross profit (Revenue – COGS), a fundamental measure of business performance.
- Smart Pricing: Knowing what each product costs to produce helps you set prices that protect your profit margins.
- Inventory Control: Monitoring COGS can help reduce excess stock and improve cash flow.
- Accurate Reporting: It’s a critical component of your profit and loss statement and is essential for year-end tax and financial reporting.
- Tax Efficiency: COGS is a deductible expense—accurate calculation can reduce your taxable profits.
6. How Your Accountant Can Support You
Managing COGS effectively can be complex—but that’s where we come in. A qualified accountant can help you:
- Identify all eligible COGS-related expenses
- Select the most suitable inventory valuation method
- Stay compliant with HMRC reporting standards
- Optimise your tax position
Final Thoughts
Cost of Goods Sold isn’t just a number—it’s a business insight tool. When calculated and monitored properly, it can help you price more effectively, improve margins, and make more informed business decisions.
If you’re looking for expert support with COGS or broader financial strategy, get in touch with our team today. We’re here to help you take the guesswork out of your numbers—so you can focus on growing your business.
Looking for a Fulham accountant to help you manage your business finances? Reach out to our team today to get started – we’d love to help.
e: office@londonaccountants.co t: 0203 137 9791
Kind Regards,
The Team at London Accountants
