How to Calculate the Cost of Goods Sold

Cost of Goods Sold (COGS) represents the direct costs associated with producing the goods a company sells. This financial metric appears on a business’s income statement, directly beneath sales revenue, and is subtracted to determine gross profit. Understanding COGS helps evaluate a company’s financial performance over a specific accounting period, such as a month, quarter, or year. It provides insight into how efficiently a business manages its production costs.

Components of Cost of Goods Sold

The calculation of Cost of Goods Sold incorporates expenses directly tied to the creation of a product. These typically include direct materials, direct labor, and manufacturing overhead. Accurately categorizing these costs helps determine the true cost of goods sold.

Direct materials are the raw materials or components that are physically incorporated into the finished product. For instance, the wood and fabric used by a furniture manufacturer are direct materials.

Direct labor refers to the wages, benefits, and payroll taxes paid to workers directly involved in the manufacturing or production process. For example, the wages of assembly line workers are considered direct labor costs.

Manufacturing overhead encompasses all indirect costs related to the production process that cannot be directly traced to a specific unit. These are expenses necessary for the factory to operate but are not directly part of the product itself. Examples include factory rent, utilities for the manufacturing facility, depreciation of factory equipment, and indirect labor within the production environment.

The Basic Calculation Formula

Calculating the Cost of Goods Sold involves a formula that accounts for changes in inventory over a period. The equation is: Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold. This formula helps determine the cost of inventory sold during the accounting period.

Beginning inventory represents the value of unsold goods a company has on hand at the start of an accounting period. This amount is typically the same as the ending inventory from the previous accounting period. It includes finished goods, raw materials, and work-in-process.

Purchases include the total cost of any new inventory acquired or produced during the accounting period. For manufacturers, this would include the cost of raw materials, direct labor, and manufacturing overhead incurred to produce goods. For retailers, it would be the cost of finished goods bought for resale.

Ending inventory is the value of the unsold goods remaining at the end of the accounting period. This figure is important because it directly impacts the Cost of Goods Sold calculation. The accuracy of this value relies on the inventory costing method used.

For example, consider a small business that started an accounting period with $10,000 in beginning inventory. During the period, they made $25,000 in new purchases. At the end of the period, a physical count revealed they had $8,000 worth of inventory remaining. Using the formula: $10,000 (Beginning Inventory) + $25,000 (Purchases) – $8,000 (Ending Inventory) = $27,000. Therefore, the Cost of Goods Sold for that period is $27,000.

Inventory Costing Methods

The method chosen to value inventory directly influences the Cost of Goods Sold and the reported ending inventory. Different costing methods lead to different financial outcomes, especially during periods of changing prices. Companies typically select one method and apply it consistently.

The First-In, First-Out (FIFO) method assumes that the first goods purchased or produced are the first ones sold. This approach aligns with the natural flow of many businesses. In a period of rising costs, FIFO generally results in a lower Cost of Goods Sold and a higher ending inventory value because the cheaper, older costs are expensed first.

The Last-In, First-Out (LIFO) method operates on the assumption that the last goods purchased or produced are the first ones sold. During a period of rising costs, LIFO typically leads to a higher Cost of Goods Sold and a lower ending inventory value. This occurs because the more expensive, newer costs are recognized as expenses.

The Weighted-Average method calculates the average cost of all goods available for sale during the period. This average unit cost is then applied to both the Cost of Goods Sold and the ending inventory. This method smooths out price fluctuations, providing a middle-ground valuation compared to FIFO and LIFO.

Specific Inclusions and Exclusions

To ensure an accurate Cost of Goods Sold calculation, understand which expenses are included and which are excluded. COGS represents only the direct costs of producing or acquiring the goods that were sold.

Inclusions in Cost of Goods Sold typically encompass the cost of raw materials, direct labor, and manufacturing overhead. This also extends to the cost of items purchased for resale, such as products a retailer buys from a supplier. Freight-in costs, which are the shipping charges to bring raw materials or finished goods to the business’s location, are also included. Additionally, storage costs for raw materials and finished products within the factory environment can be included.

Conversely, many business expenses are excluded from the Cost of Goods Sold because they are not directly tied to the production of goods. These are generally classified as operating expenses. Exclusions include selling expenses, such as advertising costs, sales commissions, and the cost of shipping products to customers. Administrative expenses, like office salaries, rent for administrative offices, and general utilities for non-production facilities, are also excluded. Interest expense on loans is another common exclusion, as it is a financing cost, not a production cost. Service-based businesses, such as accounting firms or law offices, typically do not have a Cost of Goods Sold because they do not sell physical inventory; instead, they have “cost of services.”