Consumers often check price tags to determine if the item they want to buy fits their budget. But businesses also have to consider the costs of the product they make, only in a different way.
The cost of goods sold (COGS) is the cost related to the production of a product during a specific time period. It’s an essential metric for businesses because it plays a key role in determining a company’s gross profit.
Learn more about how businesses use the cost of goods sold in financial reporting, and how to calculate it if you need to for your own business.
Key Takeaways
- Cost of goods sold (COGS) is the cost associated with producing products in a business during a specific time period.
- To calculate COGS, business owners need to determine the value of their inventory at the beginning and end of every tax year.
- Costs such as sales and marketing, salaries, and transportation are not included in COGS.
What Is the Cost of Goods Sold (COGS)?
Cost of goods sold refers to the total costs associated with the production of goods that a company sells. COGS is typically used by manufacturers, retailers, and wholesalers as these businesses sell or resell products to generate revenue.
Businesses determine COGS by calculating the value of their inventory at the beginning of the tax year, then adding in costs such as purchases, direct labor, materials/supplies, and other costs associated with creating products. The value of the inventory at the end of the tax year is subtracted from that total amount.
COGS are recorded as a business expense on income statements. It’s subtracted from a company’s total revenue to get the gross profit.
Note
The purpose of COGS is, in part, to help business decision makers, investors, and analysts determine gross profit that reveals how efficient a company is with managing production costs such as the costs for labor and supplies.
What Is Included in COGS?
Cost of goods sold includes the costs related to acquiring or producing a physical product to sell or resell. The costs often include:
- Product or raw material costs, including freight
- Direct labor costs of employees who produce the items (including any costs for contributions toward annuity plans or pensions)
- Factory overhead
- Storage costs
COGS does not include costs such as sales and marketing, but it may include all or a portion of indirect costs such as rent, taxes, repackaging, handling, and administrative costs.
Cost of Goods Sold Formula
To determine COGS, a business must identify the following:
- Beginning inventory value: Inventory will include the cost of raw materials, work in process, finished goods, and any material needs. Determine this value at the beginning of the tax year.
- Additional inventory cost: Additional inventory includes inventory costs gained throughout the tax year. What inventory was purchased during the year? What costs were associated with this inventory?
- Ending inventory value: What is the value of the inventory at the end of the year? This includes the cost of raw materials, work in process, finished goods, and any material needs for the ending inventory.
Formula for COGS
Essentially, to get the cost of goods sold, you add the beginning inventory and the additional inventory costs, then subtract the ending inventory value . The general formula for calculating COGS is:
Beginning Inventory + Purchases - Closing Inventory = COGS
For example, say your floral business had a beginning inventory of $20,000, which included the cost of all the flowers in your shop, the costs to ship them to you, and other associated costs.
Throughout the year, you may have incurred $10,000 in additional costs to buy and hold more flowers. At the end of the year, after sales, you calculate a closing inventory of $10,000. Here’s how calculating the cost of goods sold would work in this simple example:
Beginning inventory: $20,000
Purchases: $10,000
Closing inventory: $10,000
$20,000 + $10,000 - $10,000 = $20,000
Cost of goods sold: $20,000
Now, if your revenue for the year was $55,000, you could calculate your gross profit. To do this, subtract the cost of goods sold from your revenue. In this case, your gross profit would be $35,000 ($55,000 - $20,000 = $35,000).
Note
Keep in mind that in practice, calculating the cost of goods sold can be complex depending on the complexity of the company’s manufacturing process or other factors that go into the cost to make or purchase the products.
Methods for Calculating Inventory
Businesses can use one of three main methods for calculating inventory costs: FIFO (first in, first out), LIFO (last in, first out), and average cost.
The FIFO method assumes the first goods produced or purchased are the first sold, whereas the LIFO method assumes the most recent products produced or purchased are the first sold. The average cost method uses the average cost of inventory without regard to when the products were made or purchased.
Why COGS Is Important
The cost of goods sold is an important metric for a number of reasons.
- A business’s COGS will determine its gross profit on an income statement. In this way, COGS helps businesses to measure their performances, which helps executives make business decisions.
- A business that is able to manage its costs of labor and supplies throughout the production process will have a stronger gross profit. However, if it’s spending too much on the production process, the gross profit will suffer.
- The cost of goods sold is used by analysts and investors to help determine how efficiently a company is managing its production costs.
Note
COGs can play a key role in minimizing tax bills. Businesses can use COGS on the Schedule C form. By documenting expenses during the production process, a business will be able to file for deductions that can reduce its tax burden.
Frequently Asked Questions (FAQs)
How do you calculate the variable cost of goods sold?
Variable costs are costs that change from one time period to another, often changing in tandem with sales. In contrast, fixed costs are costs that remain the same. The cost of goods sold is a variable cost because it changes. To calculate it, add the beginning inventory value to the additional inventory cost and subtract the ending inventory value.
What items are included in the cost of goods sold?
The five items included in the cost of goods sold are: inventory at the start of a new tax year; purchases not including cost of items used for personal usage; labor costs; material and supplies; and other costs.
What is not included in COGS?
COGS does not include costs such as overhead, sales and marketing, and other fixed expenses. COGS only includes costs and expenses related to producing or purchasing products for sale or resale such as storage and direct labor costs.
