How to Determine Cost of Goods Sold

Cost of Goods Sold (COGS) represents the direct costs a business incurs to produce the goods it sells, including expenses directly linked to creating products or acquiring inventory for resale. Understanding COGS is fundamental for any business, as it directly impacts profitability and is a primary component reported on a company’s income statement. Accurately determining these costs allows businesses to assess their gross profit, which is the revenue remaining after accounting for the direct cost of sales.

Core Elements of Cost of Goods Sold

The calculation of Cost of Goods Sold relies on several foundational components that reflect the movement of inventory through a business. Beginning inventory refers to the value of goods a business had available for sale at the start of an accounting period. This figure typically carries over directly from the prior period’s ending inventory value.

Purchases represent the cost of new inventory acquired during the current accounting period, whether for resale or as raw materials for production. These costs include the invoice price and any freight-in charges. Purchase returns and allowances, which occur when goods are sent back or price reductions are received, reduce the total cost of these purchases.

Ending inventory signifies the value of goods that remain unsold at the close of an accounting period. This amount is determined through a physical count and then valued according to a chosen inventory costing method. For manufacturing businesses, COGS includes direct materials, direct labor, and manufacturing overhead. Retailers primarily consider the direct cost of goods purchased for resale.

Inventory Valuation Methods

Businesses employ various accepted methods to assign costs to their inventory, which directly influences both the Cost of Goods Sold and the value of ending inventory. The First-In, First-Out (FIFO) method assumes that the first goods purchased or produced are the first ones sold. The costs of the oldest inventory items are matched against sales revenue, meaning COGS reflects these earlier prices. Remaining inventory is valued using the costs of the most recently acquired items.

For example, if a business bought 10 units at $5 each and then 10 more at $7 each, FIFO would assume the initial 10 units at $5 were sold first. The Last-In, First-Out (LIFO) method assumes that the last goods purchased or produced are the first ones sold. This approach assigns the costs of the most recent inventory acquisitions to Cost of Goods Sold. Remaining ending inventory is valued based on the costs of the oldest items still on hand.

Using the same example, LIFO would assume the 10 units purchased at $7 were sold first. LIFO has historically been a common choice for businesses in the United States, particularly during periods of rising prices, due to its potential to report a higher Cost of Goods Sold and thus lower taxable income. The Weighted-Average method calculates an average cost for all goods available for sale during the period. This average cost is then applied uniformly to both the Cost of Goods Sold and the ending inventory.

To calculate the weighted average, the total cost of all goods available for sale is divided by the total number of units available. For instance, if a business had 20 units costing $100 in total, the average cost per unit would be $5. The choice of inventory valuation method can significantly impact a company’s reported financial results, especially when inventory costs fluctuate. Different methods can lead to varying figures for Cost of Goods Sold, which in turn affects reported gross profit and the value of inventory presented on the balance sheet.

Calculating Cost of Goods Sold

Determining the Cost of Goods Sold involves a systematic application of a standard accounting formula. The fundamental formula for calculating COGS is: Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold.

The initial step is to ascertain the beginning inventory, which is the value of goods on hand at the start of the accounting period. This figure typically comes from the prior period’s financial statements.

Next, calculate net purchases for the period. This involves summing the total cost of all new inventory acquired, including freight-in charges. Any purchase returns or allowances are then subtracted from this total.

Once beginning inventory and net purchases are determined, these amounts are added together to calculate the total goods available for sale. This sum represents all the inventory that could have been sold or used in production.

The next step involves determining the ending inventory value. This figure is typically obtained by performing a physical count of all unsold goods remaining at the end of the accounting period. The value of this remaining inventory is then assigned using one of the established inventory valuation methods, such as FIFO, LIFO, or the Weighted-Average method.

Finally, the determined ending inventory value is subtracted from the goods available for sale. The resulting figure is the Cost of Goods Sold for the period. For example, if a business had $10,000 in beginning inventory, made $40,000 in net purchases, and determined its ending inventory using FIFO to be $12,000, the COGS would be $10,000 + $40,000 – $12,000 = $38,000.

Consider an alternative scenario with the same beginning inventory and net purchases, but where the business uses LIFO, resulting in an ending inventory of $9,000. In this case, the COGS would be $10,000 + $40,000 – $9,000 = $41,000. These examples illustrate how the chosen inventory valuation method directly impacts the final Cost of Goods Sold figure, even with identical physical inventory levels and purchase activities.