Every business owner wants to calculate how much profit their business has made, but before that can happen, you need to calculate a very important number: costs of goods sold. Cost of goods sold, or COGS, plays an important role in your understanding profit—but how? Before we can fully dive into that question, let’s understand what it is and how to calculate it.
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What Is Cost of Goods Sold?
Cost of goods sold (COGS) is also referred to as costs of sales or costs of services. Simply put, COGS is the cost of producing a product or service. In other words, it’s the amount of money a company spends on labor, materials, and certain overhead costs. These costs are used to manufacture or purchase products that are sold to customers. While some overhead expenses do relate directly to the production of items sold, this does not include indirect expenses like utilities, marketing, or shipping expenses.
For example, if you have a furniture-making company, COGS could include items such as fabric, wood, screws, paint, and labor. Marketing costs, rent, electricity, and shipping fees would not be included since they didn’t directly contribute to the construction of any chairs or tables.
Businesses that don’t physically build or produce products like furniture can still calculate COGS. A retailer that purchases clothing from a wholesaler will charge the end consumer a markup, but the cost of purchasing the inventory before it’s sold to the end consumer counts as COGS.
COGS is important, but there’s more to learn. Check out the 36 other accounting terms we think business owners should know.
How Do You Calculate Cost of Goods Sold?
To calculate COGS, first add purchases for the period to beginning inventory, then subtract ending inventory from that number. The time period may be one year, one quarter, or even one month.
Cost of Goods Sold = Beginning Inventory + Purchases – Ending Inventory
Since we only want to calculate the cost of the merchandise that was sold during the current period, we have to start with beginning inventory. If you’re calculating COGS for the year, your beginning inventory essentially means everything you were left with at the end of the year before.
Next, add the cost of any new inventory that was purchased during the year—that gives us the total cost of inventory for the year. We can’t stop there, though. Next, subtract the ending inventory (or everything that has yet to sell) to show only what was sold during the period.
Let’s look at an example:
Let’s assume that your business uses the calendar year to record inventory. Beginning inventory will be recorded on January 1st and ending inventory on December 31st.
Company A has:
- Beginning Inventory: $80,000
- New Purchases: $250,000
- Ending Inventory: $50,000
COGS = ($80,000 + $250,000) – $50,000
COGS = $280,000
As you can see, Company A spent a total of $330,000 on their inventory during the year. However, because they were left with $50,000 worth of inventory at the end of the year, the cost of what was sold was only $280,000.
Where To Find Cost of Goods Sold
Cost of goods sold is listed on the income statement as a line between revenue and gross profit. Gross profit, which does not take operating expenses into account, is calculated by subtracting COGS from total revenue. Net income, also known as the “bottom line”, shows total profit after all expenses are subtracted.
Why Is Cost of Goods Sold Important?
The income statement is broken into several sections, allowing business owners to analyze each area of spending within the business. Cost of goods sold is one of those areas of spending that it’s important for business owners to monitor.
Gross income, or revenue less COGS, can be used to evaluate how efficient a company is in managing its labor and supplies in the production process.
Knowing the cost of goods sold is useful for analysts, investors, and business owners to estimate your company’s bottom line. If COGS increases, net income will decrease. For that reason, business owners try to keep their COGS low so their net profit will be higher.
Pricing and COGS
It’s also important to compare your COGS to your pricing. If the price your company has set for a product is lower than your COGS, then every time your product is sold, your company loses money. This is clearly bad for business.
However, industry standards for pricing also need to be taken into account. Business owners should search for ways to lower COGS where possible, whether by negotiating better terms with suppliers or sourcing less expensive supplies, while also examining how their pricing compares to the rest of the industry and to customers’ expectations.