How to Calculate Cost of Goods Sold (COGS)
Learn to accurately calculate your Cost of Goods Sold (COGS) to understand true product costs and improve your business's financial insights.
Cost of Goods Sold (COGS) represents the direct costs associated with producing the goods a business sells. This includes expenses for materials and labor directly used in creating the product. Understanding COGS is fundamental for any business that sells products, as it directly impacts profitability. Accurately calculating COGS helps companies determine gross profit, an indicator of financial health. This figure is reported on a company’s income statement and used for tax purposes.
Understanding the Components of Cost of Goods Sold
Calculating COGS involves three main components: direct materials, direct labor, and manufacturing overhead. Each plays a distinct role in determining the total cost of producing goods.
Direct Materials
Direct materials are raw substances that become an integral part of the finished product. For example, in furniture manufacturing, wood, fabric, and fasteners used to build a chair are direct materials. These costs are traceable to specific units produced.
Direct Labor
Direct labor refers to wages paid to employees directly involved in the manufacturing process, such as workers who assemble or process products. Using the furniture example, wages paid to carpenters who cut wood and assemble chairs are direct labor costs. These are distinct from administrative or sales salaries, which are not included in COGS.
Manufacturing Overhead
Manufacturing overhead encompasses all other indirect production costs not classified as direct materials or direct labor. This includes expenses like factory rent, utilities for the production facility, depreciation on manufacturing equipment, and indirect labor (e.g., salaries of factory supervisors). These costs are necessary for production but cannot be directly traced to individual units.
Inventory Systems and Valuation Methods
How a business tracks inventory and assigns costs significantly influences COGS. Two primary inventory systems are used: the periodic inventory system and the perpetual inventory system. Beyond these systems, the choice of inventory valuation method also determines how costs are assigned to goods sold and remaining inventory.
Periodic Inventory System
Under the periodic system, inventory balances are updated only at specific intervals, such as the end of an accounting period. Businesses conduct a physical count to determine the ending balance, then use this figure to calculate COGS retrospectively.
Perpetual Inventory System
The perpetual inventory system continuously updates inventory records with each purchase and sale. This system uses technology like point-of-sale scanners to track inventory in real-time, providing an up-to-the-minute balance. When an item is sold, the system immediately records its cost. While offering real-time insight, implementing a perpetual system requires more sophisticated tracking.
First-In, First-Out (FIFO)
The FIFO method assumes that the first units purchased or produced are the first ones sold. This method aligns with the physical flow of most goods, especially perishable items, and results in higher gross profit during periods of rising costs because older, cheaper inventory is expensed first.
Last-In, First-Out (LIFO)
The LIFO method assumes that the last units purchased or produced are the first ones sold. In a period of rising costs, LIFO results in a higher COGS and lower taxable income. The IRS requires that if LIFO is used for tax purposes, it must also be used for financial reporting (LIFO conformity rule). While LIFO can offer tax advantages, it may not reflect the actual physical flow of goods for many businesses.
Weighted-Average Cost
The Weighted-Average Cost method calculates the average cost of all available inventory during a period and applies that average cost to each unit sold. This method smooths out cost fluctuations by taking the total cost of goods available for sale and dividing it by the total number of units available. The resulting average cost is used for both COGS and ending inventory valuation. This approach provides a middle ground compared to FIFO and LIFO.
Calculating the Cost of Goods Sold
Once a business understands its inventory components and has chosen an inventory system and valuation method, calculating COGS involves a straightforward formula. The standard formula is: Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold. This formula applies regardless of the inventory system or valuation method used.
Beginning Inventory
To begin the calculation, a business identifies its beginning inventory, the value of all goods available for sale at the start of an accounting period. This figure is the same as the ending inventory from the previous period.
Purchases
Next, the total value of purchases made during the accounting period must be added. This includes the cost of new merchandise or raw materials acquired for resale or production, plus additional costs like freight-in charges. Purchase returns and allowances are subtracted from gross purchases to arrive at net purchases.
Ending Inventory
Finally, the value of the ending inventory is subtracted from the sum of beginning inventory and net purchases. Ending inventory represents the value of goods remaining unsold at the close of the accounting period. This value is determined by applying the chosen inventory valuation method (FIFO, LIFO, or Weighted-Average) to the physical count or perpetual records. For instance, if beginning inventory was $10,000, purchases were $50,000, and ending inventory was $15,000, the COGS would be $10,000 + $50,000 – $15,000, resulting in $45,000.