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 figure includes the cost of materials and labor directly used in creating a product. Understanding how to calculate COGS is fundamental for assessing a company’s financial performance, as it directly impacts gross profit, which is a key indicator of profitability from core operations. Accurate COGS calculation is also important for tax purposes and for making informed decisions about pricing strategies and cost management.

Understanding the Components

Calculating Cost of Goods Sold involves three primary components: beginning inventory, purchases, and ending inventory. Each of these elements plays a distinct role in determining the total cost of goods sold during an accounting period.

Beginning inventory refers to the value of inventory a company has in stock at the start of an accounting period. This value is typically the same as the ending inventory from the immediately preceding accounting period. It represents the goods carried over that are available for sale or use in the current period.

Purchases encompass the cost of all goods acquired for resale during the accounting period. For manufacturers, this includes the cost of raw materials, direct labor, and manufacturing overhead. For a retailer, purchases primarily consist of the cost of acquiring finished goods intended for resale.

Ending inventory is the value of unsold inventory remaining at the close of an accounting period. This value is determined by a physical count or through accounting records. Ending inventory is crucial because it directly reduces the cost of goods available for sale, thereby affecting the calculated COGS and ultimately the gross profit.

Inventory Costing Methods

The valuation of beginning and ending inventory, which directly influences the COGS calculation, depends on the inventory costing method a business chooses. These methods make assumptions about the flow of costs, rather than mirroring the physical flow of goods.

The First-In, First-Out (FIFO) method assumes that the first goods purchased or produced are the first ones sold. Consequently, under FIFO, the ending inventory is valued at the most recent purchase prices, which can lead to a higher reported gross profit in periods of rising costs. For example, if a company bought 100 units at $10 each, then 100 units at $12 each, and sells 150 units, FIFO would assign the first 100 units sold a cost of $10 each and the next 50 units a cost of $12 each.

The Last-In, First-Out (LIFO) method assumes that the most recently acquired goods are the first ones sold. Under LIFO, the COGS reflects the cost of the latest inventory purchases, while older, often lower, costs remain in the ending inventory valuation. This method can result in a higher COGS and lower taxable income during periods of rising prices. For instance, using the previous example, if 150 units were sold under LIFO, the first 100 units sold would be assigned a cost of $12 each, and the next 50 units a cost of $10 each.

The Weighted-Average Method calculates the average cost of all goods available for sale during a period. This average unit cost is then applied to both the units sold (COGS) and the units remaining in inventory (ending inventory). This method smooths out price fluctuations, providing a more consistent cost per unit. To illustrate, if a company had 100 units at $10 and purchased another 100 units at $12, the total cost for 200 units would be $2,200. The weighted average cost per unit would be $11 ($2,200 / 200 units). If 150 units are sold, the COGS would be $1,650 (150 units $11).

Step-by-Step Calculation

The core calculation for Cost of Goods Sold follows a straightforward formula: Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold. A business first identifies the value of its inventory at the start of the period. This figure is then combined with the total cost of all new inventory acquired during the period. Finally, the value of any unsold inventory remaining at the end of the period is subtracted from this sum. The resulting amount represents the cost directly associated with the items that generated revenue.

On January 1st, the retailer has a beginning inventory valued at $5,000. During the first quarter, the retailer makes total purchases of new products amounting to $15,000. At the end of March, after conducting an inventory count and valuing it using the FIFO method, the ending inventory is determined to be $7,000. Applying the COGS formula: $5,000 (Beginning Inventory) + $15,000 (Purchases) – $7,000 (Ending Inventory) = $13,000. Therefore, the Cost of Goods Sold for the first quarter is $13,000.

Common Adjustments to the Calculation

The “Purchases” component within the Cost of Goods Sold calculation can be affected by certain adjustments that reduce the overall cost of acquiring goods. These adjustments ensure that the purchases figure accurately reflects the net cost to the business.

Purchase returns occur when a business returns goods to its suppliers, perhaps due to defects, damage, or simply receiving incorrect items. These returns decrease the total cost of purchases, which in turn lowers the overall cost of goods available for sale and ultimately reduces the COGS.

Purchase allowances are reductions in the purchase price granted by suppliers. Unlike returns, the goods are not sent back, but the allowance still decreases the cost of the purchases. This reduction in cost similarly contributes to a lower COGS when the inventory is eventually sold.

Purchase discounts are reductions in the amount owed to a supplier, typically offered for prompt payment of an invoice. These discounts effectively lower the cost of the goods purchased. When a business takes advantage of these discounts, the net cost of its purchases is reduced, leading to a lower figure for purchases in the COGS calculation.