What is cost of goods sold (COGS) and how to calculate it

From finding investors to sourcing your suppliers, there are a million details to master when you set up your own business. But one of the most important is to have a grasp of the basic accounting principle called cost of goods sold.

This fundamental concept deals with both material and labor costs. Knowing your cost of goods sold can be key to business success, because this important figure helps you determine both the profitability of your venture and how much tax you are liable to pay.

So what is cost of goods sold? A simple explanation is that cost of goods sold is the amount it costs you in a given period of time to manufacture and sell your products. It sounds easy, but different industries will find this sum much more difficult to calculate than others.

What is included in cost of goods sold?

To fully define what is included in cost of goods sold, it is helpful to explain a few key differences between what counts as production costs in two different industries.

If you were producing software, an app, or an online training course, components of costs of goods sold would include website hosting costs, because you could not deliver your product without paying that cost. But if you were an ecommerce fashion retailer, your cost of goods sold would contain raw materials, production costs, and shipping, but not your website hosting. Why? Because you technically don’t need the website to produce and deliver your products. Instead, your website would be seen as a sales and marketing expense, and therefore excluded from cost of goods sold.

So, what is typically included in cost of goods sold for ecommerce retailers? The raw materials you use to make your product, the cost of warehousing and storage, packaging materials, shipping and delivery costs, and costs incurred processing returns. Essentially the wholesale price of each item, it also includes the direct labor costs required to produce each product.

Why is cost of goods sold important?

Why is cost of goods sold important? It’s because you’ll deduct this number from your revenue to calculate your gross profit. Often expressed as a percentage, your gross margin is a measure of your company’s profitability, and it’s an important figure when looking for investment. But knowing your cost of goods sold calculation also delivers the following benefits to your business:

Cost of goods sold can help you improve your profit margins

Understanding how much you spend to create the products you sell will not only help you price them accurately, but it can also help you identify ways to decrease your overheads.

Cost of goods sold can help you identify your most profitable products

Calculating cost of goods sold will help you determine which products are performing the best. You may decide to stop producing products that don’t make you a healthy profit, enabling you to focus your efforts where they matter most.

Cost of goods sold ensures you are taxed appropriately

Cost of goods sold is a business expense that is deducted from your total revenue, so you don’t pay tax on it.

How to calculate cost of goods sold

To explain how to find cost of goods sold, use the following basic formula.

(Cost of starting inventory + Cost of acquiring new inventory) – Ending inventory = Cost of Goods Sold.

For instance, if you started the financial year with $1,000 in inventory and bought $5,000 of goods during the year and were left with $3,000 in inventory at the end of the year, your cost of goods sold would be calculated as ($1,000 + $5,000 – $3,000 = $3,000).

But while that’s the abbreviated formula used to calculate cost of goods sold, in practice it can get a little more complicated. For taxation purposes, the cost of goods formula looks more like this:

(Inventory at the Beginning of the Year + Net Purchases + Cost of Labor + Materials and Supplies + Other Costs) – Inventory at the End of the Year = Costs of Goods Sold.

While direct labor and materials costs may be easy to identify when calculating cost of goods sold, indirect costs can be trickier. For example, cost of goods sold does not usually include general or administrative costs like salaries or wages, but you may be able to include the cost of any independent subcontractors you use, because this labor expense is directly related to the revenue you generate.

Managing cost of goods sold

Higher cost of goods sold means lower taxes, but it also means a lower bottom line, something every business will be keen to avoid. Reduce your cost of goods sold and you’ll also improve your profitability. Here’s how to do it.

Track your inventory

Businesses looking at how to manage costs of goods sold need to keep accurate stock records. For accounting and reporting purposes, it’s imperative that both your beginning inventory and your ending inventory are recorded exactly. Use reporting tools like inventory management software to help you.

Identify your least profitable products and stop making them

If you have a lot of a particular product sitting in your warehouse, it can seriously harm your profit margins. Called ‘deadstock’, it doesn’t matter how long you’ve had it for, you have to include it in your starting inventory when making your calculation. The simple answer to stop deadstock harming your profit margins? Stop making products that don’t sell, and focus on the ones that do. Use detailed sales reports to identify your least popular products, then act quickly to either decrease production or stop selling them altogether.

Shop around for raw materials

When looking at how to reduce cost of goods sold, a good place to start is at the beginning, with your raw materials. Material costs are probably one of the largest components of your cost of goods sold, so shop around for suppliers in case you can find the same material cheaper elsewhere.

Conclusion

Even if you’re a small business just starting out, it’s important to have a solid understanding of cost of goods sold. Not only will you be glad you kept an accurate record when it’s time to file your taxes, your cost of goods sold also provides you with valuable data you can use to make informed business decisions. You might use cost of goods sold to help you make improvements in your production processes or increase your prices, both of which can boost your bottom line and help you remain competitive in your chosen sector.