Cost of goods sold (COGS) is an accumulation of the direct costs that went into the goods sold by your company. This includes the cost of any materials used in production as well as the cost of labor needed to produce the good. It does not include indirect expenses such as distribution costs and marketing costs.
How to Calculate Cost of Goods Sold
While you will most likely need a CPA or tax professional to calculate cost of goods sold, you can still do a basic calculation to see how the work is done and determine the information you will give to your CPA.
Remember that the only costs you will be including in the measure for your cost of goods sold are the ones that are directly tied into the production costs of your goods or services.
Here are the 3 terms you need to know to calculate COGS:
1. Beginning Inventory
This is the total cost of every product in your inventory at the start of the year. This should be exactly the same as your ending inventory from last year, otherwise, you will need to provide an explanation as to why they are different.
2. Additional Inventory
This is the total cost of inventory that you purchased during the year.
3. Ending Inventory
This is the total cost of all the items in your inventory at the end of the year. It’s a good idea to take a physical inventory count at least once a year (if not more). Don’t assume that what your accounting software matches exactly what you have in the warehouse. Theft and damage to products are the primary reasons for differences between the inventory on the books vs. the warehouse.
Basic Calculation for Cost of Goods Sold:
(Beginning Inventory Costs + Additional Inventory Cost) – Ending Inventory = Cost of Goods Sold
The costs that go into calculating the cost of inventory are:
Cost of Purchases
This is the total amount spent for the products you placed in your inventory for selling purposes.
Cost of Materials
This is the cost of materials and supplies you need to make your product. They have to be directly related to the production of your goods.
Cost of Labor
This is the cost of paying employees who work on creating your products and services. This doesn’t include costs for employees in finance, marketing, sales, or any other areas.
These costs include shipping costs for your materials and supplies, as well as overhead costs like rent, water, and electricity for the area the products are assembled or manufactured.
Example of Cost of Goods Sold Calculation
Madeleine has a business where she sells jewelry on eBay. At the beginning of October, she did an inventory count that showed that she has $1,000 worth of jewelry in her inventory. Over the course of a year, she produces more jewelry to add to her stock, totalling $2,000 of new jewelry. At the end of the year, her inventory count shows that she has $720 of inventory on hand.
Again, the calculation for COGS looks like:
Beginning Inventory + Additional Inventory – Ending Inventory = Cost of Goods Sold
So, in this example, that would be:
1,000 + 2,000 – 720 = $2,280.
Therefore, $2,280 is the cost of goods sold.
Why is Calculating Cost of Goods Sold Important?
There are 3 key reasons why calculating the cost of goods sold is important:
1. Metric for Tax Purposes
Calculating COGS is required for your business taxes. Oftentimes people find themselves overpaying or underpaying their taxes due to a lack of record on their sales. In order to avoid this, it is imperative that you keep a record holding accurate accounts on the sales that you have made.
2. Keep Track of Profits
Business owners need to know how profitable their business is in order to determine whether it is worth staying in business. You will not be able to calculate profit without first knowing how much it is costing you yearly to produce your product or service.
3. Opportunities for the Future
When you keep track of your cost of goods sold, you can look to the future and see what areas have potential growth opportunities, and which ones you need to either improve upon, or stop producing altogether.
Calculating your cost of goods sold is necessary for any small business. Not only do you need to know this for tax purposes, it can also help you better understand how your business is doing, so you know what areas are doing well, and which you need to improve upon.
Want to learn more about taxes? Check out the small business taxes section of our website.