How to Calculate COGS From Balance Sheet

Cost of Goods Sold (COGS) is a fundamental accounting metric for businesses that sell products. It represents the direct costs associated with producing the goods a company sells during a specific period. Understanding COGS is crucial for evaluating a business’s financial performance, profitability, and operational efficiency. It provides insight into how effectively a company manages its production costs and sets its pricing strategies.

Understanding Cost of Goods Sold

Cost of Goods Sold (COGS) includes the direct expenses tied to creating or acquiring products a business sells. These direct costs typically encompass materials, direct labor, and manufacturing overhead. For instance, an automaker’s COGS would include the cost of parts and assembly line workers’ wages.

COGS is reported on a company’s income statement, appearing directly below sales revenue. Subtracting COGS from sales revenue yields a crucial profitability measure known as gross profit. A higher gross profit indicates efficient management of labor and supplies in the production process. Accurate COGS calculation is also important for tax purposes, as it is a deductible business expense that can reduce a company’s taxable income.

Key Financial Statement Components for COGS

Calculating Cost of Goods Sold under the periodic inventory system requires specific data points, some found on the balance sheet. While COGS itself resides on the income statement, beginning and ending inventory values are drawn directly from balance sheet figures. This highlights the interconnectedness of financial reporting.

Beginning inventory represents the value of a company’s unsold goods at the start of an accounting period. This figure is essentially the ending inventory from the immediately preceding accounting period. It includes finished goods ready for sale, as well as raw materials and work-in-progress inventory. This starting point is essential because it accounts for the goods already on hand before any new purchases are made.

Ending inventory, conversely, is the total value of unsold inventory at the close of a specific accounting period. This amount is determined through a physical count of goods on hand, especially in a periodic inventory system. It is reported as a current asset on the balance sheet at the period’s end. The accurate valuation of ending inventory is critical as it directly impacts the calculated COGS and the reported gross profit.

Purchases refer to the cost of goods acquired by a business during the accounting period for resale or production. This figure is typically derived from internal purchase records. To arrive at “Net Purchases,” several adjustments are made to the gross purchase amount. These include subtracting purchase returns (goods sent back to suppliers due to defects or incorrect items), purchase allowances (reductions in price for minor defects without returning the goods), and purchase discounts (reductions for prompt payment to suppliers). Additionally, freight-in costs, which are the shipping expenses incurred to bring materials or goods into the company’s possession, are added to purchases.

The COGS Calculation Formula

The standard formula for calculating Cost of Goods Sold (COGS) under the periodic inventory system is: Beginning Inventory + Net Purchases – Ending Inventory = Cost of Goods Sold. This formula reflects the flow of inventory through a business over a specific accounting period.

The first part of the formula, Beginning Inventory, establishes the starting point of goods available for sale. These are the goods that were on hand at the close of the previous period. Adding Net Purchases to this figure accounts for all the new goods acquired during the current period, after considering any returns, allowances, or discounts received from suppliers, and including any inbound shipping costs. The sum of beginning inventory and net purchases represents the “Cost of Goods Available for Sale.”

From the Cost of Goods Available for Sale, the Ending Inventory is then subtracted. The logic here is that any goods remaining at the end of the period were not sold. Therefore, by deducting the value of these unsold goods, the remaining amount represents the cost of only those goods that were actually sold during the period. This calculation provides the total expense associated with the goods sold, which is then matched against the revenue generated from those sales to determine gross profit.

Step-by-Step Calculation Example

To illustrate the calculation of Cost of Goods Sold, consider “Gadget Hub,” a hypothetical retail business, for the fiscal year ending December 31, 2024. First, identify the beginning inventory. On January 1, 2024, Gadget Hub’s balance sheet showed a beginning inventory of $50,000. This figure represents the value of all goods carried over from the end of the previous year.

Next, determine the net purchases made throughout the year. During 2024, Gadget Hub made gross purchases totaling $300,000. However, they returned $10,000 worth of damaged goods to suppliers, received $5,000 in allowances for minor defects, and took $3,000 in early payment discounts. Additionally, freight-in costs for receiving inventory amounted to $2,000. Therefore, net purchases are calculated as $300,000 (Gross Purchases) – $10,000 (Returns) – $5,000 (Allowances) – $3,000 (Discounts) + $2,000 (Freight-in) = $284,000.

Finally, ascertain the ending inventory. On December 31, 2024, a physical count revealed that Gadget Hub had $60,000 worth of inventory remaining. This value would appear on the balance sheet at the end of the current period.

With these figures, the COGS can be calculated: $50,000 (Beginning Inventory) + $284,000 (Net Purchases) – $60,000 (Ending Inventory) = $274,000. Thus, Gadget Hub’s Cost of Goods Sold for the year 2024 is $274,000. This amount would then be reported on their income statement, directly impacting their gross profit calculation.