How to Calculate Cost of Goods Sold From Balance Sheet

Cost of Goods Sold (COGS) represents the direct costs a business incurs to produce the goods it sells. It provides insight into a company’s operational efficiency and profitability. Understanding COGS is essential for interpreting a company’s financial health.

Understanding Cost of Goods Sold

COGS is subtracted from revenue to determine a business’s gross profit, which is a key indicator of profitability. A higher COGS means a smaller gross profit, impacting the overall financial picture.

For manufacturing businesses, COGS includes direct materials, direct labor, and manufacturing overhead. Direct materials are raw components, such as wood for furniture or steel for machinery. Direct labor involves wages paid to employees directly involved in the production process. Manufacturing overhead comprises indirect costs tied to production, like factory rent, utilities, or equipment depreciation.

Retail or wholesale businesses calculate COGS based on the purchase cost of merchandise for resale. This includes the price paid to suppliers, plus costs to get goods ready for sale, such as transportation or handling fees. COGS specifically excludes indirect expenses like marketing, administrative salaries, or general office expenses.

Identifying Key Inventory Figures

Calculating Cost of Goods Sold requires specific inventory figures: beginning inventory, purchases, and ending inventory. Each of these values represents a distinct aspect of a company’s inventory flow over an accounting period. Understanding where to locate these figures on financial statements is an important step in the COGS calculation.

Beginning inventory represents the value of goods a business has on hand at the start of an accounting period. This figure is the ending inventory from the immediately preceding period. It appears on the balance sheet as a current asset, dated for the end of the prior fiscal period.

Purchases include the cost of all new inventory acquired during the accounting period, whether raw materials for manufacturing or finished goods for resale. While not directly listed as “Purchases” on the income statement, this figure is derived from detailed purchase records.

Ending inventory is the value of unsold goods remaining at the close of the accounting period. This amount is also presented as a current asset on the balance sheet for the current period. Accurately determining ending inventory directly influences the calculated COGS and the company’s reported gross profit.

Calculating Cost of Goods Sold

Once inventory figures are identified, calculating Cost of Goods Sold involves a straightforward formula. This calculation provides the total direct cost associated with goods sold during a specific accounting period. It helps determine a business’s profitability.

The standard formula for calculating COGS is: Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold. This formula accounts for all goods available for sale during the period and then subtracts what was left over. The result is the cost of inventory moved to customers.

To illustrate, consider a retail business with a beginning inventory valued at $20,000 at the start of the year. During the year, the business made additional inventory purchases totaling $70,000. At the end of the year, a physical count determined that the ending inventory was valued at $15,000. Applying the formula, the calculation would be $20,000 (Beginning Inventory) + $70,000 (Purchases) – $15,000 (Ending Inventory), resulting in a Cost of Goods Sold of $75,000.

This calculated COGS figure is then used on the income statement to determine the company’s gross profit by subtracting it from total revenue. COGS calculation impacts how investors and creditors view the company’s performance.

Inventory Valuation Methods and COGS

The choice of inventory valuation method directly influences the reported Cost of Goods Sold (COGS). Businesses use one of three common methods: First-In, First-Out (FIFO), Last-In, First-Out (LIFO), or Weighted-Average Cost. Each method makes a different assumption about which inventory items are sold first, impacting the cost assigned to those sales.

Under the FIFO method, the first goods purchased or produced are the first ones sold. In a period of rising costs, FIFO results in a lower COGS because older, less expensive inventory costs are expensed first. This leads to a higher reported gross profit and potentially higher taxable income. Conversely, in a period of falling costs, FIFO would lead to a higher COGS.

The LIFO method assumes that the most recently acquired inventory items are sold first. During periods of inflation, LIFO results in a higher COGS because newer, more expensive inventory costs are matched against revenue. This higher COGS can lead to lower reported profits and lower tax liabilities. However, LIFO may not always reflect the actual physical flow of goods, especially for perishable items.

The Weighted-Average Cost method calculates an average cost for all inventory available for sale during a period. This average unit cost is then applied to both the goods sold and the remaining inventory. This method tends to smooth out the impact of price fluctuations, providing a more moderate COGS figure compared to FIFO or LIFO.