How to Calculate Cost of Goods Sold (COGS)

Cost of Goods Sold (COGS) represents the direct costs a business incurs to produce the goods it sells. This includes expenses directly tied to product creation, such as the cost of raw materials and the labor involved in manufacturing. COGS does not include indirect costs like administrative expenses or marketing, which are considered operating expenses. Businesses that make or buy goods to sell, such as manufacturers, wholesalers, and retailers, utilize COGS in their financial reporting.

The importance of COGS extends beyond simple cost tracking; it directly impacts a business’s gross profit. Gross profit is calculated by subtracting COGS from total sales revenue. A lower COGS generally results in a higher gross profit, which indicates better profitability from core sales activities. Additionally, COGS is a deductible business expense for tax purposes, meaning a higher COGS can lead to a lower taxable income and potentially reduced tax liabilities for businesses that sell goods.

Understanding the COGS Formula

The standard formula for calculating Cost of Goods Sold is: Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold. This calculation provides a snapshot of the direct costs associated with the goods sold during a specific accounting period. Businesses can calculate COGS for various periods, including a week, month, quarter, or year.

Beginning Inventory refers to the value of goods available for sale at the start of an accounting period. These are goods that were left unsold from the previous period. Purchases represent the total direct costs incurred to acquire or produce goods during the current accounting period, intended for resale. Ending Inventory is the value of unsold goods remaining at the close of the accounting period.

Calculating Inventory Values

Determining accurate inventory values is a foundational step in calculating COGS. Beginning Inventory for any given period is simply the Ending Inventory from the immediately preceding accounting period. For example, the ending inventory on December 31st of one year becomes the beginning inventory on January 1st of the next year. This ensures continuity in financial reporting.

The process for determining Ending Inventory often involves a physical inventory count, especially for smaller businesses, to ascertain the exact quantity of unsold goods. Larger operations may use spot checks to verify inventory records. The choice between a perpetual and periodic inventory system also influences how ending inventory is determined. A perpetual system continuously updates inventory records with each sale and purchase, providing a real-time balance. In contrast, a periodic system updates inventory balances only at the end of an accounting period, typically requiring a physical count to determine ending inventory.

Valuing ending inventory involves applying cost flow assumptions, as the actual cost of each item can vary. The First-In, First-Out (FIFO) method assumes that the first goods purchased are the first sold. This means that the costs of the oldest inventory are matched against sales, and the ending inventory is valued using the costs of the most recently acquired items. For example, if a business bought 100 units at $10 and 100 more at $12, and sold 150 units, FIFO would assign $10 for the first 100 units and $12 for the next 50 units to COGS, leaving 50 units at $12 in ending inventory.

The Last-In, First-Out (LIFO) method assumes the most recently purchased goods are sold first. Under LIFO, the newest inventory costs are expensed as COGS, while older costs remain in ending inventory. Using the previous example, if 150 units were sold, LIFO would assign $12 for the last 100 units and $10 for the next 50 units to COGS, leaving 50 units at $10 in ending inventory. The IRS requires businesses to file Form 970 for approval to use this method.

The Weighted-Average Cost method calculates the average cost of all goods available for sale. This average cost applies to both units sold (for COGS) and units remaining in inventory. For example, if a business had 100 units at $10 and 100 units at $12, the total cost would be $2,200 for 200 units, resulting in an average cost of $11 per unit. If 150 units were sold, COGS would be $1,650 (150 units $11), and ending inventory would be $550 (50 units $11). The choice of inventory valuation method can significantly impact reported COGS, gross profit, and taxable income.

Identifying and Including Purchases

The “Purchases” component includes all direct costs to acquire or produce goods for resale. For retailers, purchases refer to the wholesale cost of merchandise bought for sale, including the invoice price from suppliers.

For manufacturers, “Purchases” includes direct costs in the production process. This covers raw materials incorporated into the finished product, direct labor costs (wages for workers directly manufacturing goods), and manufacturing overhead like factory utilities and depreciation on production equipment, under uniform capitalization rules.

Additional costs related to acquiring inventory are added to “Purchases.” Freight-in, the cost of shipping goods from the supplier to the business, is a common example. These shipping charges are capitalized as part of the inventory cost.

Conversely, adjustments reduce total “Purchases.” Purchase returns occur when a business sends goods back to a supplier due to defects or incorrect orders. Purchase allowances are cost reductions granted by a supplier for minor defects without goods being returned. Both decrease the overall cost of purchases, impacting the final COGS calculation.