You need to know the cost of goods sold to calculate your business's profits. Calculating and defining the cost of goods sold is an important factor in setting prices and managing your business budget. So what is the cost of goods sold? How do you calculate the cost of goods sold most easily? Why is the cost of goods sold a significant element for your business finances? Here is everything you need to know about the cost of goods sold and more.
What Is the Cost of Goods Sold?
Also known as COGS, cost of sales or finished goods inventory, cost of goods sold refers to the cost that comes with goods either manufactured or purchased and then sold. The cost of goods sold is considered a business expense; therefore, it has a major effect on how much profit the company has made. The COGS can find on the business's income statement, one of the most critical financial reports regarding your company's accounting operations. You can find the cost of goods sold under the categories "income" or "sales," for which the income statement sets a report annually, quarterly, or monthly. But how to find the cost of goods sold at a certain period? Luckily, there is a standardized formula.
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What Is the Universal Cost of Goods Sold Formula?
The universal formula on how to calculate the cost of goods sold can be defined as follows:
Cost of Goods Sold = Beginning Inventory + Purchases During the Period - Ending Inventory
Another basic version of the cost of goods sold formula can be used as stated in the Balance Sheet:
- Beginning Inventory
- Plus Purchases and Other Costs (at the beginning of the period)
- Minus Ending Inventory
- Equals Cost of Goods Sold (at the end of the period)
The COGS formula can also be calculated using two methods: the accounting and inventory cost methods. The accounting method is the method required by the IRS for businesses to account for their inventory. However, this method contains a small exception that involves small businesses. Small businesses with an annual income of $26 million or less can choose not to keep an inventory and not use the accounting method for the past three years. On the other hand, the inventory cost method offers various calculation methods, including FIFO and LIFO, which vary on the type of inventory the business is keeping.
A Basic Cost of Goods Sold Example
Let's say the company has a $15,000 cost of inventory at the beginning of the year, has purchased $7,000 worth of material and products, and its ending stock has been listed as $8,000. In this case, the cost of goods sold can be calculated as follows:
- $15,000 (Cost of Inventory)
- +$7,000 (Cost of Purchases & Other Costs)
- - $8,000 (Ending Inventory)
- = $14,000 (Cost of Goods Sold)
6 Main Steps in Calculating Cost of Goods Sold
- Determine direct and indirect costs: The cost of goods sold calculation allows you to deduct the cost of products you sell, although you buy and re-sell them or manufacture them yourself. To determine the cost of direct and indirect expenses, you need to list all costs, including material, supplies, labor, and other similar costs.
- Determine facility costs: Facility costs are usually the hardest ones to determine. These usually include costs for buildings, rent or mortgage interest, utilities, and so on. An experienced tax professional can help you calculate your facility costs, considering tax percentages.
- Determine the initial inventory: Merchandise in stock, work in progress, raw materials, supplies, and finished products are all considered a part of the inventory. An important tip while calculating your beginning inventory is to ensure that the beginning inventory this year must be the same as your ending inventory last year.
- Add purchases of inventory items: Keeping track of the cost of each shipment and the total manufacturing cost for each product you add to your inventory is critical in determining this sum. Collecting invoices and any similar paperwork that accounts for purchased products is a good way to keep track of your purchase inventory throughout the year.
- Determine the ending inventory: You can achieve the ending inventory costs by conducting a physical inventory check of your products or simply estimating. Keep in mind that it can also reduce damaged inventory or deadstock from ending inventory costs.
- Calculate your COGS: You now have all the information you need to set your cost of goods sold calculator in motion.
What Does the Cost of Goods Sold Tell Your Business?
The cost of goods sold and inventory are two connection-oriented terms that go hand-in-hand when calculating a business's gross profits. It is why calculating the cost of goods sold is an essential factor in determining its profitability. Since the cost of goods sold is subtracted from a company's revenues, it helps measure the efficiency of the company and help come up with new strategies in planning labor, supply, and manufacturing process. The cost of goods sold is usually recorded as a business expense on the income statements because it is the cost of doing business. Having an exact estimation of the cost of goods sold helps managers, investors, and the finance department to forecast the company's bottom line.
So what does the cost of goods sold tell your business exactly? What happens when the cost of goods sold increases? It means that while the business will have less profit for its shareholders, this increase becomes beneficial for income tax purposes. Most companies try to keep their cost of goods sold as low as possible to keep their net profits high. Since the cost of goods sold is the cost of manufacturing or acquiring the products being sold, the only costs involved in the calculation are the ones that are directly correlated with the production of these products. In other words, COGS includes solely the direct cost of producing goods that customers purchased during a certain period.
Operating Expenses vs. Cost of Goods Sold: What's the Difference?
A common question asked regarding the cost of goods sold is the difference between the cost of goods sold vs. expenses. By now, we know that cost of goods sold is an expense and is listed in the company's balance sheet. However, there are distinctive dividing lines between the cost of goods sold and operating expenses that need to be considered.
Also known as OPEX, operating expenses refer to expenses that are not directly related to the production of goods and services. In contrast, the cost of goods sold comes from the sum of costs directly tied to the manufacturing of the products being sold. Rent, utilities, legal costs, and office supplies can be listed under OPEX. In contrast, the cost of goods sold includes materials needed to assemble a certain product or the transportation required to bring the products from a vendor to the retailer.
Accounting for Cost of Goods Sold
To make a quick recap, the cost of goods sold equals the sum of the beginning inventory cost and the purchases during the year, minus the cost of ending inventory. Both IFRS and US GAAP allow various policies for the cost of goods sold and accounting for your company's inventory. There are for main calculation methods that can use to determine your inventory cost and cost of goods sold. FIFO (First-in-first-out), LIFO (Last-in-first-out), weighted average, and specified identification are the four methods you can choose from to account for your cost of goods sold and proceed to the tax process of the operation.
How Can I Reduce the Cost of Goods Sold for My Business?
Direct costs are probably one of the most problematic issues a company will face, regardless of the product it manufactures. Reducing the cost of goods sold and keeping them at the minimum throughout the years is a key element in increasing profitability and efficiency. Here are some of the various ways you can choose to balance out your cost of goods sold and achieve an effective cost-benefit analysis.
- Benefit from the lower-cost raw material when possible.
- Purchase in large amounts to receive bulk order discounts.
- Research suppliers that have various alternatives to your products can purchase them at the lowest possible cost.
- Negotiate with your suppliers and vendors for maximum cost-efficiency.
Commonly referred to as the "pulse of the company," the cost of goods sold is a significant metric that every business needs to keep track of and understand thoroughly carefully. The cost of goods sold is useful when used appropriately, both for external users, management, and basic inventory management.COGS can help evaluate how well the company is purchasing and selling its stock while benefitting overall profitability.
Written by Erhan Musaoglu
Erhan Musaoglu is the CEO and Co-Founder of Logiwa.