How Do You Calculate Cost of Goods Sold?

Cost of Goods Sold (COGS) is a fundamental financial metric for businesses selling products. It reflects the direct costs incurred to produce or acquire goods sold during a specific accounting period. Accurately calculating COGS is crucial for assessing a business’s financial performance and profitability. This calculation provides insights into how efficiently a company manages its production or purchasing processes, directly influencing its gross profit. Businesses rely on COGS to make informed decisions about pricing, inventory management, and overall operational strategies.

What is Cost of Goods Sold?

Cost of Goods Sold (COGS) encompasses the direct expenses tied to the creation or acquisition of products a business sells. For producers, this includes raw materials, direct labor, and manufacturing overhead. For retailers, COGS primarily consists of the purchase price of goods for resale, including associated shipping costs.

COGS appears on a company’s income statement, positioned directly below revenue. Subtracting COGS from total revenue determines gross profit, indicating the profitability of core operations before other expenses. Costs not directly related to production or purchase, such as marketing, rent, utilities, and administrative salaries, are excluded from COGS and classified as operating expenses.

The Basic COGS Formula

Calculating Cost of Goods Sold involves a straightforward formula: Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold. This formula tracks the value of goods available for sale and subtracts the value of those remaining unsold.

The components are beginning inventory (value of goods on hand at the start of the period), purchases (cost of new inventory acquired during the period), and ending inventory (value of goods remaining at the end of the period). Each element contributes to accurately reflecting the cost of products sold.

Understanding Inventory Components

Beginning inventory refers to the value of goods a company has in stock at the start of an accounting period. This figure is carried over from the previous period’s ending inventory. It serves as the initial benchmark for assessing product quantity and value.

“Purchases” represents the total cost of new inventory acquired during the accounting period. This includes the direct price paid for goods and costs to bring inventory to its location, such as freight-in. Purchase returns and allowances, like goods returned or price reductions for defective items, reduce total purchases.

Ending inventory is the monetary value of unsold goods remaining at the close of an accounting period. This value is determined through physical counts or perpetual inventory systems. The ending inventory of one period automatically becomes the beginning inventory for the next, ensuring seamless financial reporting.

Inventory Cost Flow Methods

The method chosen to assign costs to inventory directly influences “Purchases” and “Ending Inventory,” impacting the calculated Cost of Goods Sold. Generally Accepted Accounting Principles (GAAP) in the United States permits several inventory valuation methods, which determine which costs are assumed to have been sold and which remain in inventory.

The First-In, First-Out (FIFO) method assumes the first goods purchased are the first ones sold. This means the costs of the oldest inventory are expensed as COGS, while the most recently acquired costs remain in ending inventory. In periods of rising costs, FIFO results in a lower COGS and a higher ending inventory value, leading to a higher reported gross profit. This method often aligns with the physical flow of goods, especially for perishable items.

The Last-In, First-Out (LIFO) method assumes the most recently purchased goods are the first ones sold. Under LIFO, the costs of the newest inventory are expensed as COGS, leaving the older, lower costs in ending inventory. During periods of rising prices, LIFO results in a higher COGS and a lower ending inventory value, which can lead to a lower reported gross profit and potentially lower taxable income. While permitted under US GAAP, LIFO is not allowed under International Financial Reporting Standards (IFRS).

The Weighted-Average Method calculates an average cost for all goods available for sale during the period. This average cost is then applied to both the units sold (COGS) and the units remaining in inventory (ending inventory). This method smooths out cost fluctuations, providing a more consistent valuation for inventory and COGS. The average cost is determined by dividing the total cost of goods available for sale by the total number of units available for sale.

Putting It All Together: A Calculation Example

Calculating Cost of Goods Sold involves applying the formula directly using determined inventory values. Consider a business that began an accounting period with $15,000 in inventory. During this period, the business made additional purchases totaling $30,000, which included $1,000 in freight-in charges.

The business also had $500 in purchase returns and allowances. Therefore, net purchases for the period were $30,000 (initial purchases) + $1,000 (freight-in) – $500 (purchase returns and allowances), resulting in $30,500. At the end of the accounting period, a physical count and valuation of the remaining inventory, using the FIFO method, determined an ending inventory value of $10,000.

To calculate the Cost of Goods Sold, the formula is applied: Beginning Inventory + Net Purchases – Ending Inventory. Plugging in the numbers, this becomes $15,000 (Beginning Inventory) + $30,500 (Net Purchases) – $10,000 (Ending Inventory). The calculated Cost of Goods Sold for the period is $35,500.