If you own a small business that sells a product, such as food or clothing, you have likely heard the term cost of goods sold or COGS. This metric is essential to business success because if the cost of goods sold is too high compared to revenue, your business could be hemorrhaging cash. Even though it is one of the most important numbers to know about your business, many business owners aren’t sure what numbers to include in a COGS formula or are intimidated by what can be a complicated calculation. Here’s a guide to help you nail down your cost of goods sold metric once and for all.
What is the Cost of Goods Sold?
Cost of goods sold is all costs involved in the production and direct sale of a product. This includes the cost of materials, shipping costs, labor, and all other costs directly associated with making a product. This does not include overhead costs, such as marketing and administrative labor. Because overhead is not included in the cost of goods sold, is it important that there is a gap between your cost of goods sold and your revenue to allow for overhead costs and profit.
Cost of goods sold is a tax-deductible number that the IRS requires businesses to report on an income statement. While most businesses have their accountant or other tax professional calculate the cost of goods sold, it is important to know what information you should keep track of during the manufacturing of your products. The following costs are the cornerstone of cost of goods sold:
Direct & indirect labor
Manufacturing and shipping costs
How to Calculate Cost of Goods Sold
The key to accurately calculating your COGS is to keep track of your costs throughout the fiscal year. Keeping track of your expenses to manufacture goods and store any inventory as you go can make it easier for you and your tax professional. It is also a good idea to have a sense of your COGS in case the cost to buy materials or other costs suddenly increases. For example, if there was a bad year for peanut plants, a peanut butter company’s COGS could spike significantly and wholesale/retail costs would also have to increase. If you are unaware of the increase in peanut prices and did not adjust your wholesale and retail prices, you might lose large amounts of money. These are the costs you should consider.
Beginning Inventory: Any parts, materials and fully manufactured products that you have at the beginning of the tax year. This number should be identical to the ending inventory number of the previous tax year.
Raw Materials: Any materials or parts purchased during the year to manufacture more of your product. For example, if your business purchases more fabric or a new manufacturing mold, that would be included in this category.
Labor Costs: The labor of any employees who work directly with the products. Direct labor costs account for people who manufacture the product. Indirect labor costs include people who are involved in packaging, shipping, and warehousing your product.
Manufacturing and Shipping Costs: Any non-labor costs of equipment or supplies used to make, ship, and store the product. This might include warehouse rent, shipping containers, and equipment leasing. This can be difficult to calculate if you have multiple products because you will need to understand how much of your warehouse rent and utilities is attributed to each product.
Ending Inventory: This is the value of any parts, materials, and fully manufactured products at the end of the tax year. Ending inventory always matches the beginning inventory of the following year.
Because the ending inventory of one year must match the beginning inventory of the following year, inaccurate measures of the cost of goods sold can cause problems in future years. If your beginning inventory does not match your ending inventory, file paperwork to explain the difference and you may owe additional taxes if the change is significant. For this reason and others, it is important to be as precise as possible.
Accounting for Inventory
In order to effectively calculate the cost of goods sold, you need a way to calculate the value of your inventory in a world with constantly changing costs. There are three main ways to calculate the cost of your inventory that all have their unique advantages.
First In, First Out (FIFO): This method of inventory cost calculation assumes that the first inventory purchased is the first inventory sold. This is the best method if the cost of goods in your industry is generally rising.
Last in, First Out (LIFO): This method of inventory assumes that the last inventory purchased in the first inventory sold. This method can give you the best break on your taxes if tax rates are high.
Average Cost: This method simply calculates the average cost of all the goods in inventory, which evens out any particularly expensive or inexpensive batches.
Keep in mind that you have to file a form with the IRS to change your accounting method, so you should be mindful of the bigger picture when choosing an accounting method. In general, the average cost method is the most straightforward for business owners who want to keep things simple.
Cost of Goods Sold Formula
Compiling all of the costs needed to calculate the cost of goods sold can be very complicated, especially when a company sells multiple products, but once you have gathered the cost of your goods sold, the calculation is actually quite simple. The formula for the cost of goods sold is:
Beginning Inventory + Purchases & Costs – Ending Inventory = Cost of Goods Sold
For example, if your scarf-making business had $14,000 of scarves and material at the beginning of the year, spent $20,000 on purchasing new fabric and knitting services, and had $10,000 worth of scarves and material at the end of the year, your COGS would be:
$14,000 (Beginning Inventory)
+ $20,000 (Purchases & Costs)
– $10,000 (Ending Inventory)
= $24,000 (Cost of Goods Sold)
One important thing to remember when calculating the cost of goods sold is that you can only calculate the cost of goods sold if you actually sell your product. Inventory that is still sitting in a warehouse is not tax-deductible because it is still an asset of yours. For this reason, it is important to understand how your product is selling because inventory is expensive to maintain if it isn’t selling. One way to ensure that you can always deduct the cost of goods sold from your business income is to produce your product based on purchase orders.
Why Does COGS Matter?
Cost of goods sold is an important metric for both legal and financial reasons. The IRS requires companies that make products to report the cost of goods sold for tax purposes, which means that businesses are legally obligated to know how much their goods cost to produce and ship. Additionally, knowing the margins between cost of goods sold and revenue is essential to keep a business profitable. If the cost of goods increases, it will be necessary to also increase prices or find a way to reduce operating or other costs.
Businesses Exempt from COGS
Businesses that only provide a service do not need to calculate the cost of goods sold because there is no inventory. Services charge clients for the labor and knowledge that they provide, so it is important for every service-based business to understand how much it costs to deliver its service. Small businesses that provide only services cannot deduct the cost of goods sold, but still, have business expenses that are tax-deductible.
In most industries, manufacturing products is one of the most costly business expenses, but it is crucial that business owners understand exactly how much each product costs to produce. Creating a margin between the cost of goods and revenue allows you to hire key people to grow the business, conduct marketing, and ultimately expand your business to its full potential.