What Is the COGS Formula and How Is It Calculated?

Cost of Goods Sold (COGS) represents the direct costs businesses incur to produce the goods they sell. It appears on a company’s income statement and is subtracted from revenue to determine gross profit, a key indicator of a business’s operational profitability. Understanding the COGS formula is important for accurate financial reporting, analyzing business performance, and making informed decisions about pricing and inventory management.

The Fundamental COGS Formula

The core formula for calculating Cost of Goods Sold is: Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold. This formula applies to most businesses that manage and track inventory. Its primary purpose is to match the cost of the goods sold during a specific accounting period with the revenue generated from those sales. This helps determine the true profitability of goods sold.

Defining Each Component

Each element within the COGS formula represents a distinct financial value essential for accurate calculation. Beginning inventory refers to the monetary value of all inventory a business possesses at the start of an accounting period. This figure is typically the same as the ending inventory from the immediately preceding accounting period, carrying over to begin the new period.

Purchases encompass the total cost of all goods acquired or manufactured for resale during the accounting period. This includes direct costs such as raw materials, finished goods, and freight-in costs. Ending inventory is the monetary value of all inventory remaining unsold at the close of the accounting period. This value is deducted from the sum of beginning inventory and purchases to arrive at the Cost of Goods Sold.

How Inventory Valuation Methods Affect COGS

The method used to value a company’s inventory directly impacts the reported value of ending inventory and, consequently, the calculated Cost of Goods Sold. The choice of inventory valuation method can significantly influence a company’s financial statements, including gross profit and taxable income. Businesses must select and consistently apply one of these methods for financial reporting and tax purposes.

The First-In, First-Out (FIFO) method assumes that the first goods purchased or produced are the first ones sold. During periods of rising costs, FIFO results in a lower Cost of Goods Sold because older, cheaper inventory is expensed first, leading to a higher reported gross profit and taxable income. This method is accepted under both U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS).

The Last-In, First-Out (LIFO) method assumes that the most recently purchased or produced goods are the first ones sold. In an inflationary environment, LIFO results in a higher Cost of Goods Sold because newer, more expensive inventory is expensed first, which leads to lower reported gross profit and reduced taxable income. While permitted under U.S. GAAP, LIFO is prohibited under IFRS.

The Weighted-Average method calculates an average cost for all inventory available for sale during the period. This average cost is then applied to both the Cost of Goods Sold and the ending inventory. This method smooths out the impact of price fluctuations and is accepted under both GAAP and IFRS.

Calculating Cost of Goods Sold

Calculating Cost of Goods Sold involves bringing together the components discussed previously. The first step requires identifying the beginning inventory, which is the value of goods on hand at the start of the accounting period. This figure directly carries over from the ending inventory of the prior period.

Next, a business calculates the total cost of all purchases made during the period, including any direct costs like freight-in. Finally, the ending inventory must be determined using a chosen inventory valuation method, such as FIFO, LIFO, or Weighted-Average. Once these three figures are established, they are plugged into the fundamental formula: Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold.

For example, if a business had a beginning inventory of $10,000, made purchases totaling $50,000 during the period, and determined its ending inventory to be $15,000, the Cost of Goods Sold would be calculated as: $10,000 (Beginning Inventory) + $50,000 (Purchases) – $15,000 (Ending Inventory) = $45,000 (Cost of Goods Sold). This calculation provides the direct cost associated with the revenue generated from sales during that period.