How to Determine COGS and Calculate It for Your Business

Cost of Goods Sold (COGS) represents the direct costs a business incurs to produce the goods it sells. This financial metric is reported on a company’s income statement, directly impacting profitability. Understanding COGS is foundational for evaluating financial health, informing pricing strategies, and assessing operational efficiency.

What is Cost of Goods Sold

Cost of Goods Sold (COGS) encompasses the direct expenditures tied to creating products a company sells. These costs are linked to the manufacturing or acquisition of goods for resale. For any business selling physical products, COGS is often the largest expense on its income statement.

COGS directly relates to gross profit, calculated by subtracting COGS from sales revenue. A lower COGS relative to sales revenue indicates a higher gross profit, suggesting better operational efficiency in production or purchasing. Unlike operating expenses such as rent, administrative salaries, or marketing costs, COGS fluctuates directly with the volume of goods produced and sold.

Elements Included in COGS

Direct materials are the raw substances and components that become an integral part of the finished product. For example, lumber for a wooden chair or fabric and thread for a garment are direct materials. These costs are directly traceable to each unit produced.

Direct labor covers the wages and benefits paid to employees directly involved in the manufacturing or production process. This includes compensation for assembly line workers or bakers. Their work directly transforms raw materials into finished products.

Manufacturing overhead, also known as production overhead, includes indirect costs related to the production process. Examples include factory rent, utilities, and depreciation of production machinery. Indirect labor, such as salaries of factory supervisors or quality control personnel, also falls under manufacturing overhead. These costs are necessary for production but are not tied to individual product units.

Inventory Accounting Methods

Different inventory costing methods directly influence reported Cost of Goods Sold, affecting a business’s gross profit and taxable income. The choice of method impacts how the cost of goods available for sale is allocated between COGS and ending inventory. Businesses select a method based on industry practices, tax implications, and financial reporting objectives.

The First-In, First-Out (FIFO) method assumes that the first units of inventory purchased or produced are the first ones sold. During periods of rising costs, FIFO results in a lower COGS, leading to higher gross profit and taxable income. This method aligns with the physical flow of goods for perishable items or those with a limited shelf life.

Conversely, the Last-In, First-Out (LIFO) method assumes that the most recently purchased or produced units are the first ones sold. In an environment of rising costs, LIFO leads to a higher COGS, resulting in lower gross profit and reduced taxable income. This method is not permitted under International Financial Reporting Standards (IFRS) but remains an option under U.S. Generally Accepted Accounting Principles (GAAP).

The Weighted-Average Cost method calculates an average cost for all units available for sale during a period and applies that average to both COGS and ending inventory. This approach smooths out cost fluctuations, providing a middle-ground result compared to FIFO and LIFO. It is useful for businesses with large volumes of identical inventory items that are difficult to track individually.

Steps to Calculate COGS

Calculating Cost of Goods Sold involves a straightforward formula that integrates key inventory values from a specific accounting period. The standard formula is: Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold. This calculation provides the direct costs associated with goods sold during the period.

Beginning Inventory represents the total value of goods available for sale at the start of the accounting period. This figure is the Ending Inventory value from the immediately preceding accounting period. It serves as the starting point for determining the total cost of goods available for sale.

Purchases include the cost of all new inventory acquired by the business during the current accounting period. For manufacturers, this encompasses the combined costs of direct materials, direct labor, and manufacturing overhead incurred to produce new goods. For retailers, it includes the cost of merchandise bought for resale, including freight-in costs, while excluding purchase returns and allowances.

Ending Inventory refers to the total value of goods remaining unsold at the close of the accounting period. This value is determined by physically counting or estimating the remaining units and applying an inventory costing method, such as FIFO or Weighted-Average, to assign a cost. For example, if a business started with $10,000 in inventory, purchased an additional $50,000, and ended the period with $15,000 remaining, its COGS would be $10,000 + $50,000 – $15,000, totaling $45,000.