How to Figure Out Cost of Goods Sold

Cost of Goods Sold (COGS) represents the direct costs a business incurs to produce the goods it sells, directly impacting gross profit and appearing on the income statement. It reflects the expense of products sold during a specific period. Understanding COGS is important for internal financial analysis and external reporting, playing a significant role in determining taxable income. The Internal Revenue Service (IRS) outlines guidelines for inventory accounting and COGS.

Understanding the Components of Cost of Goods Sold

COGS includes specific direct expenditures for production or acquisition. Direct materials are raw substances and components that become an integral part of the finished product. For example, in furniture manufacturing, direct materials include wood, fabric, and fasteners. For a reseller, direct materials are the cost of purchasing goods from a supplier.

Direct labor refers to wages and related costs paid to employees directly involved in manufacturing or preparing goods for sale. This includes salaries of assembly line workers or production staff, whose efforts are directly traceable to product creation.

Manufacturing overhead encompasses indirect costs associated with production that cannot be directly tied to a specific unit. Examples include factory rent, utilities, and depreciation of manufacturing equipment. For resellers, the primary cost is acquiring goods, which may include freight-in charges.

Selling, general, and administrative (SG&A) expenses (e.g., marketing, office salaries) are excluded from COGS. These operating expenses support the business but are not directly involved in creating or acquiring goods sold.

Calculating Cost of Goods Sold

The calculation of Cost of Goods Sold uses a standard formula: Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold. This provides the total cost of goods sold during a specific period (e.g., month, quarter, or year).

Beginning inventory represents the value of goods available for sale at the start of the accounting period. This figure is typically the same as the ending inventory from the preceding period, setting the baseline for the current COGS calculation.

Purchases include the cost of all new inventory acquired during the period. For producers, this encompasses direct materials, direct labor, and manufacturing overhead. For resellers, it refers to the cost of merchandise bought for resale. These costs also include freight-in charges, while purchase returns and allowances reduce the total purchase cost.

Ending inventory is the value of unsold goods remaining at the close of the accounting period. This amount is determined through physical counts or perpetual inventory records and impacts the final COGS figure. The method used to value this inventory influences both the balance sheet and income statement.

The choice of inventory valuation method is important because it dictates how costs flow from inventory to COGS. Different methods can result in varying COGS figures, even with the same physical inventory. The Internal Revenue Service (IRS) requires businesses to consistently apply their chosen inventory method.

The First-In, First-Out (FIFO) method assumes that the first goods purchased or produced are the first ones sold. Under FIFO, the costs of the oldest inventory are assigned to COGS, while costs of recently acquired items remain in ending inventory. During periods of rising costs, FIFO results in a lower COGS and a higher reported gross profit and taxable income.

The Last-In, First-Out (LIFO) method assumes that the last goods purchased or produced are the first ones sold. The costs of the most recent inventory are assigned to COGS, and the oldest costs remain in ending inventory. In times of rising costs, LIFO leads to a higher COGS, resulting in a lower reported gross profit and lower taxable income.

The Weighted-Average method calculates the average cost of all goods available for sale. This average unit cost is then applied to all units sold to determine COGS and to all units remaining in inventory. This method smooths out cost fluctuations, providing a middle-ground approach compared to FIFO and LIFO.

The Specific Identification method is used when individual items can be uniquely identified and their exact costs tracked. This method is suitable for businesses selling distinct, high-value items, such as custom-made jewelry or real estate. It directly matches the specific cost of each sold item to COGS, offering the most precise cost allocation.

Gathering and Maintaining Data for Cost of Goods Sold Calculation

Accurate COGS calculation relies on accurate data collection and maintenance. Robust inventory tracking systems are important for monitoring the flow of goods. These systems, whether manual or software-based, help record beginning inventory, track purchases, and determine ending inventory figures.

Record-keeping of all inventory purchases is important. This includes retaining invoices, purchase orders, and receiving reports, along with recording dates and quantities. Such documentation provides data for the “Purchases” component of the COGS formula.

Conducting periodic physical inventory counts is a standard practice. These counts verify inventory record accuracy and help identify discrepancies, ensuring the ending inventory figure is reliable. Many businesses perform these counts at least annually.

For manufacturers, tracking direct labor hours and associated costs is necessary. This data, along with manufacturing overhead costs, contributes to the cost of goods produced, which then feeds into the “Purchases” component for inventory. Modern accounting and inventory management software often streamline these processes.