Understanding Cost of Goods Sold (COGS) & What is the Calculation Formula?

The mistake that culinary business people often make is determining the basic price carelessly. In fact, the first step you have to take when starting a business is to determine the cost of goods sold (COGS) correctly.

Why is this important? So that the products you sell are not too expensive or too cheap on the market, more than that you can determine the amount of profit you want to achieve because the profits you earn can be turned back for other purposes. 

Apart from determining prices, don't forget to continue developing your product so you can remain competitive. Of course, there are costs that need to be incurred to develop this product.

So, so that you can calculate HPP correctly, let's first get to know the components that make it up and the formula below.  Read the article until the end, OK!

What's that HPP (Principal Selling Price)?

COGS, or Cost of Goods Sold, is the total cost incurred from goods sold by a company or business, in English it is called Cost of Goods Sold (COGS).

This HPP is calculated from all production costs, both direct and indirect. The main goal of calculating COGS is to ensure optimal profits. Apart from that, HPP also needs to be adjusted to a price that suits the target market's ability to pay, so that the product is well received.

COGS calculations are also important for determining gross profit and gross margin. Because, the higher the COGS that is determined, the lower the gross profit that will be obtained. 

Costs included in COGS include raw materials, labor wages, production costs, overhead and other variable costs. In short, COGS covers all costs from the beginning to the end of the production process, including non-operational costs.

What's the difference between COGS and operational costs?

COGS and operational costs are different. COGS (Cost of Goods Sold) includes direct costs incurred to sell products or services to customers. 

Examples of purchasing raw materials and direct labor wages. On the other hand, operational costs are costs related to daily business operations, but not directly related to generating income. 

To be considered operational costs, these costs must be routine expenses in running the business. For example, insurance or rental costs for a service or place.

Also read: Want your business to advance? Come on, learn about profit and loss first!

Formula and Examples for Calculating Cost of Goods Sold (HPP)

In the HPP calculation formula, there is an interrelated component, namely:  

 

 

Here's a complete guide, with examples!

1. Calculate Net Sales  

First, calculate net sales with this formula: 

For example, the Angger geprek chicken restaurant has total sales in a month of IDR 10 million. Returns from sales are IDR 3 million and there is a discount of IDR 1.5 million. So, the net sales value obtained by Angger was IDR 6.5 million.

2. Calculate Net Purchases

Next, calculate net purchases with the following formula: 

Continuing from the previous example, Angger geprek chicken has a gross purchase of IDR 5 million and delivery costs of IDR 600 thousand. 

Then the return from the purchase is IDR 150 thousand and a discount of IDR 300 thousand. So, the total net purchase of Angger geprek chicken is IDR 5.15 million.

3. Preparation of Goods

Next, to find out the value of inventory using the following formula:

 

Still with the previous example, Angger's fried chicken business has initial inventory worth IDR 3 million. But at the end of the period, IDR 1.5 million was left. So, the total inventory of goods is IDR 4.5 million.

4. Calculate COGS

After you have the net sales and net purchases figures, proceed to calculating the COGS formula. There are 2 formulas that can be used, including: 

From the example above, the total inventory of Angger fried chicken goods in a month is IDR 3 million with ending inventory of IDR 1.5 million. 

So, the HPP is worth IDR 1.5 million. Or, COGS = (Beginning Inventory + Net Purchases) – Ending Inventory

Strategy for Optimizing COGS for Maximum Profit

Determining the right COGS is not just a matter of calculating costs, but also a business strategy that can increase profitability. 

Here are several ways to optimize COGS so that your business becomes more profitable.

1. Choosing the Right Supplier

Raw material prices greatly influence COGS. Try to collaborate with suppliers who offer the best prices without sacrificing quality. 

Compare several suppliers and negotiate prices, especially if buying in large quantities.

2. Production Efficiency

Inefficient production processes can increase operational costs. Therefore, it is important to implement a more effective production system, such as reducing raw material waste, optimizing labor, and using technology to increase efficiency.

3. Reducing Overhead Costs

Overhead costs such as electricity, water and rent must be managed well. Use energy-saving equipment, utilize technology to reduce manual labor, and choose a business location that is strategic but still economical.

4. Good Inventory Management

Too much stock can increase storage costs, while too little stock can disrupt production. 

Use a good inventory management system so that raw material supplies remain optimal without any waste.

5. Utilizing ERP Technology

Using Enterprise Resource Planning (ERP) software can help in business management, including calculating COGS. 

With an integrated system, you can get accurate and efficient financial reports.

Errors that often occur in COGS calculations

To ensure accurate COGS calculations, avoid the following common mistakes:

1. Not Accounting for Unexpected Costs

Costs such as damage to raw materials, supplier price increases, and shipping costs are often overlooked in calculations.

2. Not Separating Fixed and Variable Costs

Many business owners mix fixed costs (such as renting a place) with variable costs (such as raw materials), so that the calculation results are less accurate.

3. Misvaluing Ending Inventory

Errors in calculating ending inventory can make COGS higher or lower than it should be, resulting in inaccurate selling prices.

4. Ignoring Equipment Depreciation

Production equipment that experiences depreciation in value must be included in the calculation of production costs so that the business can continue to rejuvenate equipment in the future.

The Impact of COGS on Pricing Strategy

HPP that is too high can make product selling prices expensive and less competitive. 

Conversely, if COGS is too low, the profit margin will decrease. Therefore, it is important to set prices that are not only based on COGS, but also take into account the following strategies:

1. Pricing Strategy Based on Value

Prices must be adjusted to the value perceived by customers. If the product has unique advantages, the price can be higher than competitors.

2. Cost-Plus Pricing

This method sets the price by adding a certain profit margin above the COGS. For example, if COGS is IDR 50,000 and you want a margin of 30%, then the selling price will be IDR 65,000.

3. Competitive Pricing

Compare competitors' prices according to the target market. If competitors offer cheaper prices, you can adjust your strategy by adding added value to your product.

4. Psychological Pricing

Pricing techniques such as "Rp. 99,000" instead of "Rp. 100,000" can influence customer psychology and increase sales.

COGS vs. Operational Costs

COGS and operational costs are different. COGS includes direct costs incurred to sell a product or service to customers, such as purchasing raw materials and paying direct labor. 

On the other hand, operational costs are related to the day-to-day running of the business but aren’t directly tied to generating revenue. 

For a cost to be considered operational, it must be a regular expense necessary for running the business. Examples include insurance or the cost of renting a service or space.

Read more: COGS in Business: Definition, Calculation Methods, and Management Strategies

Conclusion

So, that's how to calculate COGS easily! Make sure your financial reports are always accurate, so that COGS calculations can be more precise and you can determine the cost of goods sold that is appropriate for your business.

Oh yes, you can also adopt ERP software which provides benefits for calculating COGS, for example ESB Core with comprehensive data integration, inventory management, and increased cost efficiency of up to 35%. 

With ESB Core, HPP management becomes more effective and easier.