How to Compute the Cost of Goods Sold (COGS)
Accurately compute your Cost of Goods Sold to understand profitability. This guide explains the essential elements and valuation approaches that determine this key financial metric.
Cost of Goods Sold (COGS) represents the direct costs a business incurs to produce or acquire the goods it sells. It is a metric for businesses, providing insight into profitability and serving a role in tax calculations. The Internal Revenue Service (IRS) recognizes COGS as a deductible expense for businesses that manufacture, sell, or purchase goods, which can reduce taxable income. This financial figure directly impacts a company’s gross profit, which is calculated by subtracting COGS from total sales revenue.
COGS includes only direct costs directly tied to the production or acquisition of goods, not indirect expenses like marketing or administrative overhead. Businesses that sell physical goods or real property, essentially those with inventory, can incur COGS for federal tax purposes. Sole proprietorships report COGS on Schedule C, Profit or Loss From Business, while partnerships and corporations use Form 1125-A, Cost of Goods Sold.
Understanding the Components of Cost of Goods Sold
One such component is beginning inventory, which represents the value of goods available for sale at the start of an accounting period. This figure comes from the ending inventory value of the preceding period.
Another element is purchases, which includes the cost of new inventory acquired during the period. For merchandising businesses, this is primarily the cost of goods bought for resale, including freight. For manufacturers, this category expands to include the direct costs of goods produced, such as raw materials, direct labor, and a portion of manufacturing overhead.
Combining beginning inventory with purchases or the cost of goods manufactured yields the cost of goods available for sale. This total represents the value of all inventory that a business could have sold during the period. The final component is ending inventory, which is the value of goods remaining unsold at the close of the accounting period.
The Basic Calculation of Cost of Goods Sold
Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold. This calculation determines the direct costs associated with the goods that were actually sold during a specific reporting period. This formula is widely applicable, particularly for merchandising or retail businesses.
For example, imagine a small retail business starts the year with $10,000 in inventory. During the year, the business purchases an additional $25,000 worth of goods for resale. At the end of the year, a physical count reveals $8,000 worth of unsold inventory.
Applying the formula, the calculation would be: $10,000 (Beginning Inventory) + $25,000 (Purchases) – $8,000 (Ending Inventory) = $27,000 (Cost of Goods Sold). This $27,000 represents the direct cost of the merchandise sold by the business during that year.
Inventory Costing Methods
The valuation of both beginning and ending inventory, and consequently the Cost of Goods Sold, can differ based on the inventory costing method a business employs. Generally Accepted Accounting Principles (GAAP) allow for different methods, and the IRS requires consistency in their application. If a business decides to change its inventory costing method, it needs to obtain approval from the IRS by filing Form 3115.
The First-In, First-Out (FIFO) method assumes that the first goods purchased or produced are the first ones sold. During periods of rising costs, FIFO results in a lower COGS because older, cheaper inventory costs are expensed first, leading to higher reported profits and potentially higher tax liabilities. Conversely, in periods of falling costs, FIFO results in a higher COGS.
The Last-In, First-Out (LIFO) method operates on the assumption that the most recently purchased or produced goods are the first ones sold. In an inflationary environment, LIFO leads to a higher COGS as newer, more expensive inventory costs are expensed, resulting in lower reported profits and potentially reduced tax liabilities. The LIFO method is not permitted under International Financial Reporting Standards (IFRS), but it is allowed under U.S. GAAP.
The Weighted-Average Method calculates an average cost for all goods available for sale during a period. This average cost is then applied to both the units sold (COGS) and the units remaining in ending inventory. This method tends to smooth out price fluctuations, providing a more consistent cost per unit. The choice of inventory costing method is a decision, as it directly influences the reported profitability and tax obligations of a business.