What is cost of goods sold?
Cost of goods sold (COGS) is how much it costs to produce your product or service. This includes the material or labor expenses used to make your product, also known as direct expenses. Some indirect expenses like marketing, shipping fees or packaging are excluded in your cost of goods calculation. Typically, the cost of goods sold focuses on the value of your inventory, which can be items you’ve purchased for resell or creating and selling your own product.
Taking inventory and calculating your COGS at the start and end of an accounting period helps you accurately understand your inventory’s value. You’ll list your business’ cost of goods sold on your income statement, which reports your income for a specific accounting period.
Why is calculating COGS important?
Knowing your COGS helps you better understand the financial standing of your business. Common benefits of calculating COGS in your small business include:
- Easier to price your products: Understanding how much it costs to create your products can help you figure out how to price your item and create a beneficial profit margin.
- Understand your business’ profit: Use COGS to learn how much your business earns before paying taxes and other expenses.
Roles you can hire to calculate your COGS for you
If your business’ inventory is too large and time consuming to calculate on your own, you might want to hire someone to calculate the cost of goods sold for you. This employee typically meets with you regularly to determine your financial standing, calculate your COGS and other tax materials and suggest additional ways to improve your financial status.
Roles you can hire to calculate your cost of goods sold include:
- Budget analyst
- Financial analyst
- Financial manager
- Financial counselor
- Tax advisor
What is the formula for COGS?
Before calculating COGS, gather information to input into your formula. This includes:
- Costs to purchase inventory: Total cost you paid for all the items in your inventory
- Labor costs: Amount you paid workers to make and ship your products to you
- Beginning inventory: Total value of all your products and material in your inventory at the beginning of the accounting period
- Ending inventory: Total value of all your inventory’s items at the end of the accounting period
- Material and supply costs: Amount you paid for the materials and supplies used to make and ship your product
- Other costs: Additional costs like rent to store your items, containers to ship products or freight expenses.
The cost of goods sold formula is:
Beginning inventory + purchases and other costs – ending inventory = COGS
How to calculate COGS
Follow the steps below to calculate your business’ cost of goods sold:
1. Gather and list all your costs
You can deduct all the costs it takes to develop the product you sell, whether it’s the materials used to create them or products you purchase to resell. Collect and track these costs. For example, if you sell soap and haircare products, list direct and indirect costs used to create them including ingredients like oils and liquids, scales and measuring cups and containers to hold the soap. Include payment for employees who make and ship the soap.
Factor in your facility costs. A tax or accounting professional may help figure these out. These costs include your rent or mortgage, utilities and other costs to store each product during that accounting period.
2. Note your beginning inventory
Your beginning inventory is the cost of all the materials you purchased to sell at the beginning of the accounting period. For instance, if you bought soap holders to sell with your soap, list their price in your beginning inventory. Other merchandise materials include stock, materials still being used to make the product, raw materials not yet used, finished products and supplies accompanying the items.
If customers return your products, subtract these from purchases you made during that accounting period. Your beginning inventory for this accounting period should be the same figure as the ending inventory for the previous accounting period.
3. Add inventory item purchases
Keep track of other product costs like inventory shipment or the manufacturing cost for each product added to your inventory. Keep the invoices, receipts or any other paperwork of every item purchased to calculate and factor into your overall COGS formula.
4. Find your ending inventory
Determine the ending inventory costs by physically taking inventory of your products. Note any items deemed damaged, out of date or destroyed. Write down the estimated value of your damaged products. Out of date items that receive little profit must have supporting evidence to prove they’re decreasing in value. You must also prove that destroyed items are significantly damaged enough to be considered worthless.
Your ending inventory is all of your items gathered and tallied together. It should be the same number as your beginning inventory at the start of the next accounting period.
5. Calculate your COGS
Input all of your information into the COGS calculation once it’s gathered. Using the aforementioned formula, input your inventory and product cost details.
For example, if your beginning inventory is $500,000, your purchases and other costs are $300,000 and your ending inventory is $200,000, your formula would look like this:
500,000 + 300,000 = $800,000 – $200,000 = $600,000
This makes your cost of goods sold for that accounting period $600,000. Depending on your preference, your accounting period can be every month, quarter or year. Include this final COGS calculation on your business’ income statement.