How to Find COGS and Calculate It for Your Business

Cost of Goods Sold (COGS) is a fundamental accounting concept that directly impacts a company’s profitability and financial health. It represents the direct costs associated with producing the goods a business sells during a specific period.

Understanding Cost of Goods Sold

COGS reflects the direct expenses involved in creating or acquiring the products a business sells. It appears on a company’s income statement, positioned directly beneath revenue, and is subtracted to arrive at gross profit. COGS differs from operating expenses, which include costs like rent, administrative salaries, or marketing. Operating expenses are indirect costs, meaning they are not directly tied to the product’s production or acquisition. Distinguishing between COGS and operating expenses is important for assessing a business’s true profitability.

Key Components of COGS

The specific elements comprising COGS vary depending on the business model. For manufacturing businesses, COGS includes direct materials, direct labor, and manufacturing overhead.

Direct materials are raw goods that become part of the finished product, such as fabric for clothing. Direct labor refers to wages paid to employees directly involved in production, like assembly line workers. Manufacturing overhead encompasses indirect production costs, such as factory utilities and depreciation on equipment. These costs are necessary to produce the goods but are not directly traceable to each individual unit.

For retail or merchandising businesses, COGS primarily consists of the direct cost of purchasing inventory for resale. This includes the actual purchase price of goods from suppliers and freight-in costs. Adjustments for purchase returns and discounts also modify the total cost of purchases.

Calculating COGS and Inventory Valuation

The fundamental formula for calculating COGS is Beginning Inventory + Purchases (or Cost of Goods Manufactured) – Ending Inventory. Beginning inventory represents the value of goods available for sale at the start of an accounting period. Purchases refer to the cost of new inventory acquired during the period, while ending inventory is the value of unsold goods remaining at the end of the period.

The value assigned to both beginning and ending inventory is significantly influenced by the inventory valuation method a business chooses. The Internal Revenue Service (IRS) permits several methods for valuing inventory, which directly impacts the calculated COGS and, consequently, taxable income. Businesses must consistently apply their chosen method and generally need IRS approval to change it.

One common method is First-In, First-Out (FIFO), which assumes that the first goods purchased are the first ones sold. Under FIFO, the ending inventory is valued using the most recent costs, and COGS reflects the older costs during periods of rising prices. For example, if a business bought 10 units at $10 each, then 10 more at $12 each, and sold 15 units, the COGS under FIFO would be the first 10 units at $10 and 5 units from the second batch at $12, totaling $160.

Another method is Last-In, First-Out (LIFO), which assumes that the last goods purchased are the first ones sold. This means ending inventory is valued at older costs, and COGS reflects the more recent costs during periods of rising prices. Using the same example, under LIFO, the COGS for 15 units sold would be the last 10 units at $12 each and 5 units from the first batch at $10, totaling $170.

The Weighted-Average Method calculates a single average cost for all units available for sale, regardless of their purchase timing. This average cost is then applied to both the units sold and the units remaining in inventory. For instance, if 10 units were bought at $10 and 10 units at $12, the total cost for 20 units is $220. The average cost per unit is $11 ($220 / 20 units), and if 15 units were sold, the COGS would be $165 (15 units x $11).

COGS Across Business Types

The application and calculation of COGS vary across different business models. For retail or merchandising businesses, COGS focuses on the direct cost of goods acquired for resale, including purchase price and freight-in costs.

Manufacturing businesses have a more complex COGS calculation because they create the products they sell. Their COGS includes direct materials, direct labor, and manufacturing overhead, which contribute to the “cost of goods manufactured.” This cost then becomes the “purchases” equivalent in the basic COGS formula.

Service-based businesses that also sell physical products apply COGS only to those product sales, not to the cost of providing services. For example, a hair salon selling shampoo and conditioner would calculate COGS for those product sales, but the stylists’ wages or salon rent would be operating expenses. Purely service-based businesses, such as consulting firms, typically do not have a COGS line item on their income statements.

Importance of COGS for Business

Accurately calculating and understanding COGS is important for evaluating a business’s financial health and making informed decisions. COGS directly impacts a company’s gross profit, calculated by subtracting COGS from total sales revenue. Gross profit then influences the gross margin, a profitability ratio showing the percentage of revenue remaining after accounting for COGS.

COGS is also used in setting appropriate sales prices for products. Businesses use COGS as a baseline to ensure their pricing strategy covers direct costs and contributes to profit. Without a precise understanding of COGS, a business might unknowingly price products too low, leading to insufficient profitability.

From a financial analysis perspective, COGS provides insights into a company’s operational efficiency and cost management. A rising COGS relative to sales could indicate increasing production costs or supply chain inefficiencies. Businesses can analyze COGS trends to identify areas for cost reduction and process improvement.

COGS has significant tax implications for businesses. It is a deductible expense on federal income tax returns, reducing taxable income. Incorrectly reported COGS can lead to over or underpayment of taxes, potentially resulting in penalties or interest charges from the IRS. Businesses that produce income by manufacturing, selling, or purchasing goods can deduct COGS on Schedule C.