How to Figure Cost of Goods Sold for Your Business
Unlock accurate business profitability by learning to precisely calculate the direct costs tied to your sales. Gain clarity on your financial performance.
Cost of Goods Sold (COGS) is a fundamental accounting concept for businesses engaged in selling physical products. It represents the direct costs tied to producing or acquiring the goods that a business sells during a specific period. Understanding COGS is essential for accurately assessing profitability and overall financial health, as this metric directly impacts a company’s true earnings from sales.
Businesses must precisely calculate COGS to gain a clear picture of their operational efficiency. It serves as a direct indicator of the costs associated with generating revenue. Without a proper understanding of COGS, a business might misinterpret its gross profit, which is the profit before considering operating expenses. This understanding allows for more informed decision-making regarding pricing strategies, production costs, and inventory management.
Defining Cost of Goods Sold
Cost of Goods Sold includes all direct expenditures linked to the creation or acquisition of goods a company sells. For manufacturers, this encompasses raw materials, direct labor, and manufacturing overhead. Manufacturing overhead includes indirect costs like factory rent, production facility utilities, and depreciation of manufacturing equipment.
For retailers or wholesalers, COGS primarily represents the direct cost of purchasing finished goods from suppliers for resale. This includes the invoice price and any expenses to bring goods to the seller’s location and prepare them for sale. COGS appears on a company’s income statement, subtracted from net sales revenue to arrive at gross profit. This calculation highlights the profitability of a company’s core sales activities.
COGS differs from operating expenses, which are indirect costs not directly tied to production or acquisition. Operating expenses include administrative salaries, marketing, office rent, and administrative utility bills. These are reported separately on the income statement, below gross profit, as they relate to general business operations rather than direct product costs.
Key Components of the Calculation
Calculating Cost of Goods Sold requires specific financial data. The first component is beginning inventory, which is the value of all goods on hand at the start of an accounting period. This figure is carried over from the previous period’s ending inventory and serves as the starting point for tracking the flow of goods. For example, if a business ended 2024 with $50,000 in inventory, its beginning inventory for 2025 would be $50,000.
The next component is purchases, which includes all new inventory acquired or produced during the current period. For manufacturers, purchases cover raw materials, direct labor, and manufacturing overhead. For retailers or wholesalers, purchases represent the total cost of finished goods bought from suppliers.
Purchases also include costs directly associated with preparing goods for sale, such as freight-in (shipping and handling to transport inventory to the buyer’s location). These direct costs are added to the initial purchase price. Exclude expenses not directly tied to inventory, like selling expenses, administrative costs, or freight-out.
Finally, ending inventory represents the total value of goods remaining unsold at the end of the accounting period. This value is determined through a physical count or a perpetual inventory system. This ending inventory becomes the beginning inventory for the next period, directly impacting the COGS calculation.
Putting the Formula into Practice
The standard formula for calculating Cost of Goods Sold is: Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold. This formula combines the value of inventory at the start of a period with new acquisitions, then subtracts the value of inventory remaining at the end.
To use this formula, first determine beginning inventory. For example, if a small online retailer had $10,000 worth of products in stock on January 1st, this is their beginning inventory.
Next, calculate total purchases made during the accounting period. This includes the cost of all new goods bought for resale, along with any freight-in charges. If the retailer spent $35,000 on new inventory and $1,500 on shipping, total purchases would be $36,500.
Finally, determine ending inventory, the value of all unsold goods remaining at the close of the accounting period. If the retailer has $8,000 worth of inventory left on March 31st, this is their ending inventory.
Plugging these numbers into the formula yields the Cost of Goods Sold. Using the example: $10,000 (Beginning Inventory) + $36,500 (Purchases) – $8,000 (Ending Inventory) = $38,500. The retailer’s Cost of Goods Sold for that quarter is $38,500.
Understanding Inventory Valuation Methods
The inventory valuation method a business chooses influences ending inventory and, consequently, Cost of Goods Sold. These methods dictate how the cost of goods is assigned to items sold versus items remaining in inventory. The three methods are First-In, First-Out (FIFO), Last-In, First-Out (LIFO), and the Weighted-Average method. The choice can impact a company’s reported financial performance, particularly its gross profit.
The First-In, First-Out (FIFO) method assumes the first goods purchased or produced are the first ones sold. This method often aligns with the natural flow of perishable goods or items with expiration dates. In a period of rising inventory costs, FIFO typically results in a lower Cost of Goods Sold because older, cheaper inventory costs are expensed first. This leaves newer, more expensive inventory in ending inventory, leading to a higher reported ending inventory value and gross profit. For instance, if a business buys 10 units at $5, then 10 units at $7, and sells 10 units, FIFO assigns the $5 cost to units sold, resulting in $50 COGS.
Conversely, the Last-In, First-Out (LIFO) method assumes the most recently purchased or produced goods are the first ones sold. While it may not reflect the physical flow of goods for many businesses, LIFO is allowed for financial reporting under U.S. Generally Accepted Accounting Principles (GAAP) and for tax purposes. During periods of rising costs, LIFO generally results in a higher Cost of Goods Sold because newer, more expensive inventory costs are expensed first. This leads to a lower reported ending inventory value and a lower gross profit. Using the previous example, if a business buys 10 units at $5, then 10 units at $7, and sells 10 units, LIFO assigns the $7 cost to units sold, resulting in $70 COGS.
The Weighted-Average method calculates an average cost for all goods available for sale. This average cost is applied to both units sold and units remaining in ending inventory. This method smooths out price fluctuations, resulting in a COGS and ending inventory value that fall between FIFO and LIFO during periods of changing costs. For example, if 10 units were bought at $5 and 10 units at $7, the total cost is $120 for 20 units, making the average cost $6 per unit. If 10 units are sold, COGS would be $60. Businesses must apply their chosen method consistently across accounting periods.