Too many startups and SMBs get caught up in the world of accountancy.
As a business owner, you’re not just running a business. You’re also ensuring that your numbers are in check.
Getting just one number wrong means that, like a house of cards, the rest of the calculations tumble. It’s no wonder 1 in 5 businesses fail within the first year.
One such number is the cost of goods sold, commonly referred to as COGS. Any business that has inventory needs to understand the costs involved.
In this article, we’ll dive more into what COGS is and why it matters, go over the GOGS formulas and answer some frequently asked questions.
What is the cost of goods sold (COGS)?
COGS is an accounting term that refers to the value of inventory sold (or created if you’re the manufacturer) in a particular time period.
COGS summarizes the aggregate of all the costs it takes to bring your consumer goods or services to the market.
It represents the amount you must recover when selling a product or service to break even before bringing in a profit, otherwise known as the break-even point. To turn a profit, you should ensure that your COGS is less than the dollar amount your business charges clients to buy your goods or services.
What’s included/excluded in COGS?
COGS for a manufacturer includes the expenses that go into the production of every product or service you sell – raw materials, direct labor, direct factory overheads, etc.
COGS for a retailer, distributor, or middleman is much simpler to determine since you’ll just have to look into inventory.
COGS excludes indirect costs like distribution expenses. So, do NOT factor things like marketing expenses, shipping fees or utilities into the COGS.
How to calculate COGS
Let’s get down to the real business.
The formula for calculating COGS with the small business inventory model is pretty straightforward:
COGS = Beginning inventory + Purchased inventory – Ending inventory
This formula takes into consideration the dynamic ebb and flow of business inventory over a set period. Business costs can fluctuate based on supply and demand, pricing, depreciation and much more.
Now, let’s demonstrate this formula equation by considering a real-world small business example.
Say you own a shoe store with revolving inventory and seasonably changing products. You record the beginning inventory July 1 and the ending inventory on Sept. 30, the end of the third quarter.
You begin Q3 with inventory that has a retail value of $55,000 and costs you $30,000 to acquire. But in the middle of summer, demand increases, so you purchase $45,000 in additional inventory with a total retail value of $95,000.
Due to sales of the new seasonal summer stock plus sales of fall/winter items, you’re only left with inventory worth $45,000 at the end of the quarter. This end inventory cost you $25,000 to acquire.
Let’s plug in these numbers: To calculate the COGS, we would begin with $30,000 (beginning inventory) + $45,000 (additional inventory purchases) – $25,000 (end inventory) = $50,000 (COGS).
This means that the total amount directly traceable to the shoes the store had to spend was $50,000.
Note that the gross margin for that time period ($55,000 +$95,000 – $45,000) is positive, implying a solid business month.
Revenue that’s less than the COGS would hint at a financially challenging month for the business.
If revenue is constantly lower than the COGS over several months, interventions such as reducing business expenses and overhead or increased pricing should be considered.
Calculating COGS with the manufacturing or production model
Here, you need to include the sum of all the direct costs of production.
Continuing with our shoe example, a shoe manufacturer would need raw materials (leather, rubber, foam, synthetics, thread), machinery for cutting, sewing and assembly, and labor to create shoes. All of these would be examples of direct costs of production.
To calculate the COGS for manufactured goods:
COGS = Cost of goods manufactured + Opening finished goods inventory – Ending finished goods inventory
Extended COGS formula
This is a more detailed formula that includes extra components such as allowances, discounts, returns and freight charges.
COGS = Starting inventory + Purchases – Purchase returns & allowances – Purchase discounts + Freight in – Ending inventory
Consider a company called ABC that manufactures packets of fireworks.
Note that the direct cost of manufacturing one packet is $4, and below are the other stats:
• Opening inventory: 6,000 packets
• Closing inventory: 2,000 packets
• Freight in $40,000
• Discounts received: $9,000
• Purchase costs: $100,000
The cost of opening inventory: 6,000 x 4 = $24,000
The cost of closing inventory: 2,000 x 4 = $8,000
COGS= $24,000 + $100,000+ $40,000 – $9,000 – $8,000 = $147,000.
COGS versus operating expenses
As a business owner, you’re probably well aware of operating expenses. But do you understand the difference between COGS and operating expenses?
If not, operating expenses are costs you incur during normal business operations to keep your business up and running. Operating expenses are essentially the opposite of COGS and can include selling, general and administrative expenses.
Chances are, if an expense does not fall under COGS, it falls under operating expenses.
COGS and taxes
Businesses that manufacture and sell products or buy and resell products need to calculate their COGS to accurately determine how much to pay as their taxes.
The IRS lets you include COGS in your tax returns and overall reduces the amount you pay as your tax. A higher COGS means you need to pay fewer taxes, but it also means that you’re not making enough profits.
Why the COGS matters
• Your COGS is directly connected to your business profits; monitoring it will help you keep tabs on the financial health of your business. Knowing your business’s profits can help you seek financing, make financial decisions and determine whether you need to make adjustments.
• Your COGS determines whether your pricing model reflects market demands. Pricing your goods is one of the biggest tasks you have as a business owner. Charging the wrong prices means you could wind up losing out on profits.
• Your COGS is often your biggest business expense, so this metric is critical for tracking your income and cash flow. COGS can also give you an idea of the kind of sales your business needs to generate in order to grow.
• COGS will help you manage your taxes.
Choosing an accounting method for COGS
The cost of inventory varies throughout the year.
That means given the variation in the cost of your expenses, your COGS will also fluctuate. To satisfy the IRS, these changes should be considered in your final calculation of COGS.
The common inventory costing techniques are:
FIFO (first in, first out): FIFO is the standard shelf stacking practice for many stores. The first items produced or bought are the first sold. This generally means that you sell your least expensive items first. As a result, you record a lower COGS.
LIFO (last in, first out): In stark difference to FIFO, the last goods produced or bought are the first sold. With this method, your COGS might be higher.
Average cost: Calculate the average cost per item. This method gives you a weighted average unit cost and keeps your COGS more level than the first two methods.
Specific identification: This method is used by organizations with specifically identifiable inventory, such as with a serial number on vehicles, boats, or large pieces of equipment. Items are listed with their respective costs included. The cost of each specific unit is then used to denote your COGS.
Which method you should use will depend on your inventory type. The IRS stipulates specific guidelines for which method you can use and when you’re allowed to make changes to your inventory cost method.
Here are frequently asked questions about COGS:
1. How is the COGS classified in financial statements?
Because it’s deemed a cost of doing business, COGS is documented on the business’s income statement as an expense.
You’ll typically find this metric on the line directly below total revenue when looking at your business’s income statement.
2. Is COGS the same as profit?
After determining COGS, you can calculate your business’s gross profit for the period, which is one of the seven KPIs entrepreneurs must track. Gross profit refers to revenue left over after subtracting the costs of making a product or providing a service.
To calculate gross profit, use the following formula:
Gross Profit = Revenue – COGS
3. Is it better to have a higher or lower COGS?
To ensure clarity, you should look at your COGS for a specific time period (a year, a quarter, a month, etc.) and equate it to a different time period of the same length to determine how sales changed.
That said, COGS is best when it’s low.
If it’s high, you’ve earned little profit. What you want to do is cut COGS by lowering how much you spend on inventory.
4. What are the three main components of COGS?
The three main components of COGS are:
1. The value of your inventory at the start of the month (or quarterly, depending on your accounting practices).
2. Inventory purchases made during that month.
3. The value of the remaining inventory at the end of the month.
COGS best practices
Since COGS is vital to your business, taking the initiative to optimize it now will benefit you in the future.
Here are a few things you can do to control your COGS:
• Work out a deal with your supplier – Suppliers are open to negotiating the prices of what they sell if you can commit to an exclusive agreement, buy in bulk, or sign onto a long-term partnership. If you manage to work out a deal, you can lower the cost of this inventory and maintain the price for your customers. The result will be more profits for you and no change in quality for customers.
• Minimize theft and waste – Theft and waste can create a huge variance between the inventory you buy and the inventory you sell. Focus on prioritizing efficiency and overseeing transactions. Doing this ensures that every piece of inventory is going into the final product and every final product is going to a customer. Doing this will go a long way in controlling your COGS.
• Organize COGS by category – Looking at COGS for a specific product or category will help you measure sales more accurately. To achieve this, you will need to come up with a classification and organization system that works for your report.
COGS is one of the best indicators of your business’s revenue, profit and sustainability.
Not only do you need to know how to calculate your COGS for tax purposes, but if you can reduce this metric through more efficiency or through better deals with suppliers, your business can be more profitable.