How to Find the Cost of Goods Sold for Your Business

Cost of Goods Sold (COGS) represents the direct costs attributable to the production of the goods sold by a company during an accounting period. This fundamental accounting measure is presented on a company’s income statement and is subtracted from net sales revenue to determine gross profit. Understanding COGS is important for any business that sells products, as it directly reflects the expense of acquiring or producing the items generating revenue. Accurately calculating COGS allows businesses to assess profitability and gain insight into the efficiency of their production or procurement processes. This figure is important for financial reporting and making informed operational decisions.

Key Components of Cost of Goods Sold

The calculation of Cost of Goods Sold relies upon three specific data points related to a business’s inventory. The first component, beginning inventory, represents the value of all unsold goods a business possessed at the start of a new accounting period. This figure is the ending inventory value from the preceding accounting period. It encompasses finished goods, work-in-process, and raw materials that were on hand before any new production or purchases began for the current period.

The second component involves purchases, which include the cost of all new inventory acquired by the business during the current accounting period. This includes the invoice price of goods bought from suppliers, along with any freight-in costs. Businesses must adjust this total for any purchase returns and purchase allowances.

The final component, ending inventory, represents the total value of unsold goods remaining on hand at the close of the accounting period. This figure is determined by valuing the items still in stock at the period’s end. The ending inventory of one period automatically becomes the beginning inventory for the subsequent accounting period.

Standard Calculation Method

Calculating the Cost of Goods Sold involves a formula that integrates the three inventory components. The standard method begins by determining the cost of goods available for sale, which is the sum of the beginning inventory and the total purchases made during the period. This combined figure represents all the inventory a business could have sold over the accounting period. For instance, if a business started with $50,000 in beginning inventory and made $200,000 in purchases during the year, including all freight-in and adjusted for returns, the cost of goods available for sale would be $250,000.

After establishing the cost of goods available for sale, the next step involves subtracting the ending inventory from this total. This subtraction isolates the cost of only those goods that were actually sold during the period, rather than those remaining in stock. Continuing the example, if the business determined its ending inventory to be $60,000 at the end of the year, this amount is deducted from the $250,000 cost of goods available for sale. The resulting Cost of Goods Sold would be $190,000.

This calculation, expressed as: Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold, provides a clear and consistent method for determining the direct costs associated with revenue. It ensures that only the costs of the products that generated sales are matched against those sales on the income statement. This approach is fundamental to accrual basis accounting, allowing for accurate financial reporting and a clear representation of a business’s gross profit.

Impact of Inventory Valuation Methods

The method a business chooses to value its inventory significantly influences the reported Cost of Goods Sold and, consequently, its gross profit. Different inventory costing methods allocate the costs of goods available for sale between the Cost of Goods Sold and the ending inventory balances. The First-In, First-Out (FIFO) method assumes that the first units of inventory purchased or produced are the first ones sold. Under FIFO, the costs of the oldest inventory items are assigned to COGS, while the costs of the most recently acquired items remain in ending inventory.

Conversely, the Last-In, First-Out (LIFO) method assumes that the last units of inventory purchased or produced are the first ones sold. With LIFO, the costs of the most recent inventory acquisitions are assigned to COGS, and the costs of the oldest inventory items are left in ending inventory. While LIFO is permitted for U.S. federal income tax purposes under Internal Revenue Code Section 472, International Financial Reporting Standards (IFRS) prohibit its use. The choice between FIFO and LIFO can result in substantially different COGS figures, especially during periods of fluctuating inventory costs.

The Weighted-Average Method calculates the average cost of all goods available for sale during the period. This average cost is then applied to both the units sold (COGS) and the units remaining in ending inventory. This method smooths out cost fluctuations, as it does not prioritize any specific purchase order.

Direct Versus Indirect Costs

When determining the Cost of Goods Sold, businesses include only those expenses directly tied to the production or acquisition of the goods sold. These are primarily direct materials, direct labor, and manufacturing overhead. Direct materials are the raw goods that become a physical part of the finished product, such as the wood used in furniture or the fabric in clothing. Direct labor refers to the wages paid to employees who physically convert raw materials into finished products or are directly involved in the production process, like assembly line workers.

Manufacturing overhead encompasses all other costs incurred in the factory or production facility that are necessary to produce goods but cannot be directly traced to specific units. Examples include factory rent, utilities for the production plant, depreciation on manufacturing equipment, and the salaries of factory supervisors. These costs are allocated to the products produced and become part of the inventory’s cost, eventually flowing into COGS when the products are sold.

Expenses that are not directly related to the production or acquisition of goods are specifically excluded from the Cost of Goods Sold. These are categorized as operating expenses, known as selling, general, and administrative (SG&A) expenses. This category includes costs such as marketing and advertising expenses, sales commissions, office salaries, administrative staff wages, and rent for administrative offices. These expenses are not part of the cost of the product itself, and they are reported separately on the income statement below the gross profit line.