How to Determine Cost of Goods Sold
Knowing your cost of goods sold (COGS) is essential to understanding business profitability and making informed financial decisions. Cost of goods sold is the direct costs associated with producing or purchasing the goods or services your business sells during a specific period.
In this guide, we'll cover what cost of goods sold is, how to calculate it, and why it matters.
What is cost of goods sold?
Cost of goods sold includes all the direct costs tied to producing or procuring the goods and services you sell in your business. However, for service-based businesses, this metric is more commonly known as "cost of services" or "cost of sales."
For simplicity's sake, we'll use the term cost of goods sold throughout this article.
When you subtract your cost of goods sold from your total revenue, the result is your gross profit—a key performance indicator (KPI) that can help you evaluate your pricing strategies, profitability, and the efficiency of your production processes.
Your cost of goods sold might include:
Raw materials costs. The cost of materials used to produce goods or the cost of purchasing finished goods for resale.
Direct labor costs. Wages paid to employees directly involved in production or service.
Manufacturing overhead. Costs like factory utilities and equipment maintenance.
Inventory storage costs. The cost of storing raw materials and inventory waiting to be sold.
Freight and shipping costs. The cost of getting sold products to customers.
Fuel costs. The cost of driving to a job site to perform a service.
Cost of goods sold does not include indirect costs such as marketing costs, management salaries, or administrative expenses. These are operating expenses, and they appear elsewhere on your income statement.
A good rule of thumb for deciding whether to include an expense in cost of goods sold is, "Would the cost exist if we didn't produce the product?" If the answer is no, it likely belongs in cost of goods sold.
How to calculate your cost of goods sold
To calculate cost of goods sold accurately, you'll need the following information:
Beginning inventory. The total value of inventory at the start of the accounting period.
Purchases during the period. The cost of additional inventory acquired, direct labor costs, and other direct costs like storage and freight.
Ending inventory. The total value of inventory remaining at the end of the period.
Once you have this information, the formula to calculate cost of goods sold is simple:
Beginning inventory + Purchases - Ending Inventory = Cost of Goods Sold
Of course, getting to those numbers isn't always easy. To help you out, here's a step-by-step guide.
Track your inventory
First, you need to maintain detailed records of your raw materials and finished inventory coming into the business and inventory sold. Using inventory management software to automate tracking can reduce errors.
Account for purchases
Make sure you have a process for tracking all purchase invoices and receipts. Factor in shipping and handling costs if they're directly tied to acquiring products.
Conduct regular inventory counts
Perform physical counts periodically to match actual stock with recorded amounts. Adjust for any discrepancies from theft, damage, or loss.
Choose an inventory valuation method
There are several methods to value inventory, which impact your cost of goods sold calculations:
First-in, first-out (FIFO). This is the most widely used valuation method. It assumes you sell the oldest inventory first. First-in goods are typically cheaper than those that come in later because material prices and other inventory costs tend to rise due to inflation. As a result, FIFO generally results in a lower COGS, higher gross profit, and a higher tax liability.
Last-in, first-out (LIFO). The LIFO method assumes you sell the newest inventory first. It tends to result in a higher cost of goods sold and a lower income tax bill.
Weighted average cost method (WAC): This method averages the cost of all inventory items available. While it simplifies inventory costing, it's typically only used when all inventory items are identical.
Specific identification. This method tracks the cost of each individual item from purchase to sale. Typically, you'd only use the specific identification method for high-value or one-of-a-kind items.
Adjust for additional costs
Include costs like storage, packaging, and freight if they directly contribute to product availability.
If you use accounting software, most of these calculations are handled for you.
Common cost of goods sold calculation problems
While cost of goods sold is easy to calculate, a few issues can trip you up.
Inconsistent recordkeeping. Failing to update inventory records regularly can lead to errors. Also, inconsistent classification of expenses can lead to wrong calculations. For example, some companies misclassify operating expenses like workplace supplies or utility bills in cost of goods sold. This leads to an incorrect number for gross income.
Incorrect inventory valuation. Choosing the wrong valuation method—or applying different valuation methods to different periods—can distort financial statements. For example, if you used LIFO to value beginning inventory and FIFO to value ending inventory, you may overstate or understate taxable income.
Overlooking inventory adjustments. You need to conduct regular inventory counts and adjust for obsolete inventory, theft, damage, or loss. When you ignore these adjustments, your inventory values will be overstated, as will your cost of goods sold.
Why accurate cost of goods sold calculation matters
Think calculating your cost of goods sold is just a number-crunching exercise? Think again. Properly calculating COGS allows you to:
Determine gross profit, which is a key indicator of profitability and financial health
Price products effectively to ensure profitability
Prepare accurate tax returns and avoid audits and penalties
Make data-driven decisions for inventory management and cost control
Get help calculating and interpreting your cost of goods sold
Do you struggle with tracking inventory, classifying transactions, or selecting the right valuation method? Slate can provide the support and insights you need to streamline your accounting processes, prepare complete and accurate financial reports, and make informed financial decisions.
Reach out today to speed up your bookkeeping and financial reporting processes and your operations stay on the right track.