What is Cost of Goods Sold (COGS)?
Cost of Goods Sold is also known as COGS or Cost of Sales. It is a critical financial metric that indicates the direct cost of creating or acquiring the goods a company sells during a given time period. This figure helps companies determine their gross profit and is key to understanding how well the organization is controlling expenses, managing labor, and tracking supplies.
So how do you determine this important number? At first it seems like a simple formula:
COGS = (beginning inventory + purchases) – ending inventory
But in reality, calculating the cost of goods sold for profit/loss statements, income tax, or other purposes can be a daunting task for many businesses. This figure takes into consideration a number of factors, which may vary based on the characteristics of your business. These may include:
- Cost of items purchased for resale
- Cost of raw materials or parts
- Transportation and storage costs
- Labor costs directly related to product production
- Utilities and other overhead costs directly related to product production
- What you sell (products, services, or both)
- Your business structure (sole proprietorship, partnership, LLC, corporation, etc.)
- Your accounting period (calendar year, fiscal year, short tax year, etc.)
- The method (cost, lower of cost or market, or retail) used to determine inventory value
- The cost flow (FIFO, LIFO, specific, or average) used to account for changes in inventory cost
- The accounting method (cash or accrual) implemented in your organization
- Inventory items that are broken, stolen, obsolete, or otherwise not saleable at full price
Failure to account for an applicable cost can give you a false picture of your financial situation and lead to unpleasant surprises later.
To further complicate things, there may be special rules, restrictions, and qualifications imposed by the IRS based on your business structure and industry. Most of these are explained at excruciating length in IRS Publication 538.
How to Calculate Cost of Goods Sold
Cost of Goods Sold (COGS) is calculated by adding the cost of your beginning inventory and the purchases made during the period, then subtracting the costs of your ending inventory.
COGS= (beginning inventory+ purchases) – ending inventory
According to the IRS, you should include all of the following as inventory:
- Merchandise or stock in trade.
- Raw materials.
- Work in process.
- Finished products.
- Supplies that physically become a part of the item intended for sale.
There could be more things to add to this list based on your unique business situation.
In most cases, you should include purchases of products, supplies, and overhead expenses directly related to inventory.
Do not include general items such as management salaries, sales costs, advertising, or other expenses not directly involved with inventory. In most cases, depreciation expenses should not be considered in the cost of items purchased. Nor should you include the cost of supplies, equipment, or services that are used for purposes other than building inventory.
Fortunately, after the end of an accounting period, determining beginning inventory for the next period is usually easy—just use the previous closing inventory figure, unless there are unusual exceptions.
Which Accounting Method to Use for Determining COGS
If the actual cost of each item in your inventory is known, you may simply add up the costs to determine the value of your inventory. Alternatively, you could use the average cost of each item, multiplied by the number of items in stock.
In more complicated situations, you may choose to use FIFO or LIFO methods to calculate inventory value, as explained below. Be aware that your chosen method will directly affect your balance sheet, cash flow statement, and other key financials.
FIFO means First-In-First-Out. FIFO is the most common and easiest accounting method to use for calculating Cost of Goods Sold.
FIFO assumes that the first items you purchased are the first ones you sold. Therefore, the items currentlyin inventory are valued at the most recent cost.
Since, in general, costs tend to rise over time, using the FIFO method of accounting to determine inventory value for COGS means the current inventory is may be valued higher than the inventory sold. It generally gives you a relatively high inventory valuation and low COGS.
LIFO means Last-In-First-Out, and is basically the opposite of FIFO. It usually results in a higher COGS and a lower closing inventory value, which can result in lower taxes. Be aware, however, that using the LIFO method requires permission from the IRSand has very complex rules. See sections 472 through 474 of the Internal Revenue Code for more details.
Additionally, the International Financial Reporting Standards Foundation (IFRS) prohibits using LIFO for international trade.
Which Reporting Method to Use for COGS
Once you have determined the cost of your inventory, you may choose to report it on your financial statements and tax returns in one of three ways:
- Actual cost
- Lower of cost or market value
- Retail value
You need to carefully determine with the help of competent financial advisors which method works best in your individual situation. Also be aware that there are special IRS requirements for each method.
Once your methods are chosen and your inventory values and purchases are totaled, it’s time to perform the COGS calculation.
Determining Cost of Goods Sold (COGS) & Using the Data for Financial Strategies
After calculating beginning inventory, ending inventory, and inventory-related purchases, you can find the Cost of Goods Sold using the formula shown at the beginning of this article.
Here’s an example:
If your beginning inventory is valued at $1,000,000, your ending inventory is $900,000, and your inventory-related purchases total $400,000, you would calculate COGS as follows:
COGS = ($1,000,000 + $400,000) – $900,000
COGS = $500,000
COGS is valuable not only for financial reporting, but also for analyzing profitability, making inventory purchasing decisions, or even making key decisions on which products to keep and which to cut.
Determining COGS is also essential in calculating Gross Income and Net Income:
Gross Income = Gross Revenue – COGS
Net Income = Revenue – Expenses – COGS
You can also calculate the COGS for individual products in order to determine pricing strategies. For example, suppose you sell Red Flying Widgets for $50.00 each. You have 100 in stock and you calculate the cost of goods sold at $4500, or $45 per widget. This would mean you are only making $5.00 gross profit on each sale. If this were the case, the COGS would inform your financial and operation teams that you may need to consider a price increase or cost reduction for this product.
Having accurate figures for your Cost of Goods Sold is essential to running a profitable business. It offers valuable insights into profitability that can assist in pricing, inventory, product offerings, and more. If you’re not sure whether your company is accurately calculating COGS or are unsure how to use the financial data from these reports to make more informed strategic decisions, reach out. Our CFOs are happy to help.
About the Author
Wes Anderson, CFO
Wes Anderson is an experienced CFO with significant international finance experience. In his previous roles as Director of Financial & Tax Reporting, Senior Financial Controller, and Chief Financial Officer in the international travel industry, Wes coordinated two corporate restructurings involving entities in four countries. He also built and executed financial models consolidating multiple foreign subsidiaries into a parent holding company.
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