Before you start calculating your business’s profit, you need to know your cost of goods sold. And, knowing what the cost of goods sold is plays an important role in setting prices. But what is the cost of goods sold?
Understand what the cost of goods is, how to calculate it, and why it’s important for your small business.
What is cost of goods sold?
The cost of goods sold (COGS), also referred to as the cost of sales or cost of services, is how much it costs to produce your products or services. COGS include direct material and direct labor expenses that go into the production of each good or service that is sold.
When calculating the cost of goods sold, do not include the cost of creating goods or services that you don’t sell.
COGS does not include indirect expenses, like certain overhead costs. Do not factor things like utilities, marketing expenses, or shipping fees into the cost of goods sold.
If you own a cabinetry company, examples of COGS would include the wood, screws, hinges, glass, paint, and labor used to make the cabinets you sell. However, the costs to market the cabinets, the electricity needed to operate the machinery, and shipping are not included in the COGS.
To find the COGS on a product, add up the cost of raw materials and direct labor needed to create it.
Cost of goods sold formula
To find the cost of goods sold during an accounting period, use the COGS formula:
COGS = Beginning Inventory + Purchases During the Period – Ending Inventory
Your beginning inventory is whatever inventory is left over from the previous period. Then, add the cost of what you purchased during the period. Subtract whatever inventory you did not sell at the end of the period.
Accounting periods might be months, quarters, or calendar years.
Cost of goods sold example
Let’s say your business is using the calendar year for recording inventory. Beginning inventory is recorded on January 1st, and ending inventory is recorded on December 31.
Your business has a beginning inventory of $9,000, makes purchases valued at $5,000, and is left with an ending inventory of $2,000. Use the COGS formula.
COGS = $9,000 + $5,000 – $2,000
COGS = $12,000
Your cost of goods sold for the year is $12,000. Knowing this number helps you make decisions, such as finding new vendors with better direct material prices.
Now that you know your COGS, you can find your business’s gross profit for the period.
Let’s say you have revenues of $50,000. Subtract your COGS of $12,000 from $50,000. For the period, your gross income is $38,000.
Why do you need to know your COGS?
Here are some reasons why you must know your cost of goods sold.
COGS and pricing
Product pricing is one of the most difficult responsibilities you have. You need to price items just right to sell them and turn a profit.
If you know your cost of goods sold, you can set prices that leave you a healthy profit margin. And, you can determine when prices on a particular product need to increase.
Let’s say your cost of goods sold for Product A equals $10. You need to price the product higher than $10 to turn a profit.
COGS and business profits
Once you know your cost of goods sold, you can calculate your business’s gross income or profit, which is the amount your business earns from selling your offerings before subtracting taxes and other expenses. And when you know your business’s gross profit, you can calculate your net income or profit, which is the amount your business earns after subtracting all expenses.
Here is the gross profit formula:
Gross Income = Gross Revenue – COGS
And, here is the formula to find net profits:
Net Income = Revenue – COGS – Expenses
As you can see, knowing your business’s COGS is an integral part of calculating your overall business profits. And, you need to know your business profits to seek financing and make financial decisions.
Accounting for the cost of goods sold
Which financial statements do you record cost of goods sold on?
Record your business’s COGS on your small business income statement. COGS appears under your business’s sales, or revenue. Deduct your COGS from your revenue to get your gross profit.
Your COGS also play a role when it comes to your balance sheet. The balance sheet for small business lists your business’s inventory under current assets. List your ending inventory for the accounting period.
Changes in COGS
Your cost of goods sold can change throughout the accounting period. Your COGS depends on changing costs and the inventory costing methods you use.
The three inventory costing methods are:
- FIFO (first in, first out)
- LIFO (last in, first out)
If you use the FIFO method, the first goods you sell are the ones which you purchased or manufactured first. Generally, this means that you sell your least expensive products first. As a result, you record a lower cost of goods sold.
Under the LIFO method, you sell the latest goods you purchased or manufactured. Your COGS might be higher.
With the average method, you take an average of your inventory to determine your cost of goods sold. This keeps your COGS more level than the FIFO or LIFO methods.
Are you tracking the numbers you need to compute your cost of goods sold? Patriot’s online accounting software makes it easy to record business expenses. Plus, we offer free, U.S.-based support. Get your free trial today!
This article has been updated from its original publication date of 08/25/2015.
This is not intended as legal advice; for more information, please click here.