Cost of goods sold, often referred to as COGS, is an accounting term that articulates the direct costs of manufacturing or producing the items your company sells. Your business has plenty of reasons to know its cost of goods sold. Chiefly, your COGS will help determine just how profitable your business really is.
In this article, we’ll define cost of goods sold, show you how to calculate cost of goods sold, clarify the cost of goods sold formula, and underscore the importance of COGS.
What is cost of goods sold?
Cost of goods sold, by definition, accounts for all the direct costs of producing inventory your business intends to sell. This includes the cost of any items your business must purchase or create to manufacture or produce a product it will later sell. Costs that can be tied directly to the production process—including labor, overheard, and materials—are also included.
Here is a list of the direct costs that should be folded into your cost of goods sold:
- Any items purchased that will be resold
- Any raw materials purchased that will be used to create a for-sale product
- Any parts purchased that will be used to create a for-sale product
- Direct labor costs
- Any supplies used to either make or sell the product
- Manufacturing overhead costs, including utilities
- Direct shipping and freight charges
- Any direct container costs
Note that the indirect costs are not included in COGS. Most notably, this includes office maintenance and overhead, sales, and marketing.
Cost of goods sold formula
The formula for cost of goods sold is:
Whether you need to determine COGS for the month, quarter, or entire year, you should ensure you are working with data from one period. That’s because the COGS you calculate will reveal how much cash your business spent on the inventory you sold over a defined time frame. (Annual tax returns; for example, will articulate COGS for an entire year.)
To solve for COGS, calculate the value of your beginning inventory at the start of the determined period, then add the costs incurred (purchases, and labor or direct sales costs, if applicable) to acquire and manufacture new inventory over that period of time. Once you subtract the value of the remaining inventory at the end of the given period, you are left with your cost of goods sold.
Cost of goods sold example
Here’s an example. Say a paint manufacturer starts the fiscal year with $100,000 in beginning inventory at retail price. Over the year, they spend an additional $50,000 on purchases, including direct labor costs. By the end of the year, they have $75,000 worth of ending inventory.
($100,000 + $50,000) – $75,000 = $75,000
In other words, the business has a cost of goods sold of $75,000 for the fiscal year.
Limitations of cost of goods sold
Like all formulas, COGS has some limitations. It’s not an exact science, and how you count inventory, calculate inventory value, and categorize your direct costs can affect your numbers. A good accountant can help you find the most accurate way to keep inventory records and determine the cost of goods sold. Once you pick a strategy, stay consistent.
Need a more “time-sensitive” estimate of your inventory’s value? Moving average cost may help shine a light on your costs for fast-moving inventory.
Why do you need to calculate cost of goods sold?
Calculating COGS is essential for a variety of reasons. Here are the top two:
1. To get a handle on your business’s spending and pricing
When you sit down to calculate the cost of goods sold, you’re forced to take a long, hard look at the many expenses that your business incurs producing for-sale inventory. From raw materials to labor to shipping and freight costs, there’s a laundry list of direct costs to consider. Sitting down and reviewing these expenses will not only help you calculate COGS, but may also highlight areas where your business is wasting precious resources.
Knowledge is power, and understanding where your team might be overspending can help you make cuts that aren’t serving your business’s bottom line. Reviewing COGS thoroughly—if you choose to calculate it individually for top-selling items—may also identify what items are not as profitable. For instance, you may think a high-priced item is profitable because your customers pay a high amount for it—but when you take a good look at the numbers, the COGS is extremely high. Once you review what your competition is charging for such an item, you may decide to either lower your costs or charge more for the item.
2. To accurately claim expenses on business tax returns
Cost of goods sold isn’t just a helpful accounting calculation. Your business needs to determine COGS to properly file corporate taxes. That’s because, by law, you must report your cost of goods sold if you wish to write that spending off as a business expense. This is another reason why keeping organized, accurate inventory records is crucial.
Using cost of goods sold in accounting
Cost of goods sold is an essential accounting calculation. Plus, when you subtract COGS from your business’s revenue, you’ll solve for gross profit, a key component in evaluating your business’s financial health. After all, gross profit reveals how much money your company is truly making, and how well its managing labor and supply costs.
Keep in mind that, unlike inventory or assets, your COGS is neither an asset nor a liability on your balance sheet. Instead, COGS should be coded as an “expense.” Your accounting team will need to track when inventory is sold off to match those expenses.
If that seems confusing, simply think of COGS as a cost of doing business. Without spending that money, your company can’t sell what it needs to sell. And while a higher COGS may lower your tax implications, it also indicates that your business is generating less profit. That’s why every business is constantly trying to find ways to lower the cost of goods sold.
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