How to Determine the Cost of Goods Sold

The Cost of Goods Sold (COGS) represents the direct costs a business incurs to produce the goods it sells. This figure is a fundamental part of a company’s financial statements, directly impacting profitability. Understanding COGS is necessary for businesses to assess their gross profit, calculated by subtracting COGS from revenue. This figure is crucial for internal financial analysis and strategic pricing decisions.

COGS is also a deductible expense that reduces a business’s taxable income, making it important for tax purposes. Businesses that manufacture, sell, or purchase goods must calculate COGS to fulfill tax obligations, often reported on IRS forms like Schedule C for sole proprietors or Form 1125-A for corporations.

Identifying the Core Components

Determining the Cost of Goods Sold involves tracking several financial elements throughout an accounting period.

Beginning Inventory

Beginning Inventory refers to the value of goods a business had on hand at the start of an accounting period. This figure typically comes from the ending inventory balance of the previous period. It encompasses all products that were ready for sale, including raw materials, work-in-progress, and finished goods.

Purchases

Purchases represent the direct costs associated with acquiring or producing goods intended for sale during the period. This includes the cost of raw materials, the direct labor involved in manufacturing, and direct manufacturing overhead. Costs such as freight-in, which is the cost of shipping goods to the business, are also included because they are necessary to get the goods ready for sale. Importantly, these purchases are distinct from indirect expenses, like administrative salaries or marketing costs, which are not directly tied to production.

Ending Inventory

Ending Inventory is the value of goods that remain unsold at the close of the accounting period. To determine this value, businesses typically perform a physical count of their stock. This figure is then used in the COGS calculation and becomes the beginning inventory for the next accounting period.

Understanding Inventory Tracking Approaches

Businesses employ different systems to manage and track their inventory, which directly influences how inventory figures are determined and how COGS is calculated.

Perpetual Inventory System

The Perpetual Inventory System continuously updates inventory records with each purchase and sale. This means that inventory balances and the Cost of Goods Sold are adjusted in real-time as transactions occur. Businesses using this system often rely on automated tools, such as point-of-sale (POS) systems and barcode scanners, to maintain precise, up-to-the-minute records of stock levels. This approach provides immediate insight into what is in stock and the cost of goods sold, which can be beneficial for managing stockouts and optimizing reordering processes.

Periodic Inventory System

In contrast, the Periodic Inventory System updates inventory records only at specific intervals, such as the end of an accounting period. Under this system, businesses typically conduct a physical count of their inventory to determine the ending balance. Purchases are recorded in a temporary account throughout the period, and the inventory account is updated only after the physical count is completed. This method is often simpler to manage for businesses with lower transaction volumes or less need for real-time inventory information.

Applying Inventory Valuation Methods

After tracking inventory, businesses must assign a cost to items, a step in determining both the value of ending inventory and the Cost of Goods Sold. The method chosen can significantly impact a company’s financial statements and tax liability. The IRS permits the use of several inventory valuation methods.

First-In, First-Out (FIFO)

The First-In, First-Out (FIFO) method assumes that the first goods purchased or produced are the first ones sold. This means that the Cost of Goods Sold is based on the cost of the oldest inventory, while the remaining ending inventory is valued at the cost of the most recently purchased items. FIFO often aligns with the physical flow of goods for many businesses, especially those dealing with perishable items. In periods of rising costs, FIFO generally results in a lower Cost of Goods Sold and a higher ending inventory value, leading to higher reported net income and potentially higher tax liability.

Last-In, First-Out (LIFO)

Conversely, the Last-In, First-Out (LIFO) method assumes that the last goods purchased or produced are the first ones sold. Under LIFO, the Cost of Goods Sold reflects the cost of the most recent inventory acquisitions, while the ending inventory consists of the older, lower-cost items. During inflationary periods, LIFO typically results in a higher Cost of Goods Sold, which leads to lower reported net income and a reduced tax burden.

Weighted-Average Method

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 Cost of Goods Sold and the ending inventory. This method smooths out price fluctuations, providing a middle ground between FIFO and LIFO. It is often simpler to apply, particularly for businesses with a large volume of similar, undifferentiated inventory items. The weighted-average method can be less volatile in its impact on financial results compared to FIFO or LIFO during periods of significant price changes.

Executing the COGS Calculation

After identifying core components and valuing inventory, the final step is to calculate the Cost of Goods Sold using a standard formula.

The fundamental formula for Cost of Goods Sold is: Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold.

For example, if a business starts an accounting period with $10,000 in beginning inventory, makes $50,000 in purchases throughout the period, and ends with $15,000 in inventory, the calculation would be straightforward. Adding the beginning inventory and purchases ($10,000 + $50,000 = $60,000) yields the total cost of goods available for sale. Subtracting the ending inventory ($60,000 – $15,000 = $45,000) then provides the Cost of Goods Sold for that period, which is $45,000. This result represents the direct cost of the products that generated revenue for the business during the period.