How To Calculate Cost of Goods Sold (With Examples)

In today’s dynamic business environment, tracking expenses is more crucial than ever. From payroll and marketing to supplies, rent, commissions, and the cost of goods sold (COGS), understanding your financial landscape is essential for success.

If you are in management, accounting, or running your own business, you may frequently encounter the term “cost of goods sold.”

For businesses that maintain and sell inventory, calculating COGS is essential. This metric not only plays a vital role in financial reporting but also aids in evaluating the overall financial health of your company.

A higher COGS typically leads to lower profit margins, while a lower COGS can enhance profit margins.

What Is the Cost of Goods Sold (COGS)?

The cost of goods sold (COGS), also known as cost of sales, represents the direct costs incurred in producing or acquiring the goods sold by a business.

COGS includes direct material costs and direct labor expenses but excludes indirect costs such as marketing and shipping.

All businesses with inventory must calculate their COGS for each accounting period, which may be monthly, quarterly, or annually, depending on the company’s preference.

Tracking COGS is a requirement and should be included on your business’s income statement, commonly referred to as the Profit and Loss Statement (P&L).

Without knowing your COGS, accurately calculating your business’s profits is impossible.

Calculating Cost of Goods Sold (COGS)

The formula for calculating COGS is straightforward:

To compute your COGS, it’s essential to understand each component of the COGS formula:

1. Beginning inventory. This is the value of the inventory at the start of the accounting period, representing leftover inventory from the previous period.

2. Cost of goods. This includes the expenses incurred to purchase or manufacture products during the accounting period, covering both materials and labor.

3. Ending inventory. This is the value of the inventory at the end of the accounting period. The ending inventory of the current period becomes the beginning inventory of the next.

   Investing time in inventory management is crucial for accurate COGS calculation.

Why Do You Need to Know COGS?

Understanding COGS is vital for any business. It’s not only significant for tax purposes—being a deductible expense—but also crucial for assessing the overall health of your enterprise.

Accurate calculation of COGS enables you to determine your “true cost.” With COGS known, you can calculate your gross profit.

Gross profit is found by subtracting COGS from revenue:

Inventory Costing Methods and COGS

The inventory costing method you select will influence your COGS calculation significantly.

There are three primary inventory costing methods:

1. First In, First Out (FIFO). This method assumes that the first items purchased are the first sold. Given that material and labor costs usually rise over time, FIFO typically results in selling the least expensive products first, leading to an increase in net income over time.

2. Last In, First Out (LIFO). In contrast to FIFO, this method sells the most recently acquired products first. As costs tend to increase over time, LIFO emphasizes selling the higher-cost items first, which often results in a decrease in net income.

3. Average Cost. This approach averages the cost of inventory items, allowing for a consistent COGS calculation without regard to purchase or manufacturing dates.

Cost of Goods Sold (COGS) and Your Taxes

COGS is a deductible expense for businesses. The IRS provides detailed guidelines on accurately calculating COGS, which must be followed to avoid potential audits.

Where you report COGS on your tax return depends on your business structure:

1. Sole proprietors and single-owner LLCs. Report your COGS on Schedule C, specifically in Part III, alongside other expenses to determine your net income. Your net income will be reported on Line 12 of Part I.

2. C corporations, S corporations, partnerships, and multiple-owner LLCs. Use Form 1125-A for these calculations, which can be complex, so seeking professional assistance is advisable.

   • Corporations. Report COGS on Form 1125-A, with net income on Line 2 of Form 1120.

   • S Corporations. Report COGS on Form 1125-A, with net income on Line 2 of Form 1120S.

   • Partnerships and multiple-owner LLCs. Report COGS on Form 1125-A, with net profit on Line 2 of Form 1065.

Service-Based Companies and Cost of Goods Sold

Many service-based companies may offer products, but many operate without inventory. If no goods are sold, COGS cannot be calculated, and thus cannot be claimed. However, businesses can claim the Cost of Services, which focuses on direct costs associated with the provision of services, excluding indirect costs.

Direct Costs vs. Indirect Costs

To accurately calculate COGS or Cost of Services, it is essential to differentiate between direct and indirect costs.

COGS comprises only direct costs, which are directly tied to a “cost object”—the product or service—and includes costs related to the production or acquisition of that product.

Direct costs can be either fixed or variable, typically encompassing direct labor and material costs.

Indirect costs, on the other hand, are overhead expenses remaining after direct costs have been calculated. These operating expenses (OPEX) do not directly tie to a specific “cost object” and include materials, labor costs unrelated to specific products, rent, utilities, office supplies, payroll, insurance, and marketing.

Both direct and indirect costs can be classified as fixed or variable. For example, rent is generally a fixed cost, while utilities can vary based on usage.

Cost of Revenue vs. Cost of Goods Sold

While related, the cost of revenue and COGS are not identical. The cost of revenue encompasses COGS (or Cost of Services) plus any additional sales-related costs.

In addition to production costs, the cost of revenue includes marketing, shipping, distribution, commissions, and discounts applied, while excluding indirect costs.

Limitations of Cost of Goods Sold (COGS)

While tracking COGS is essential for tax filing and profit calculation, it does have its drawbacks:

1. COGS figures can be manipulated, allowing anyone wishing to “cook the books” to adjust numbers in their favor, such as overstating returns or inventory values.

2. Errors in COGS calculations can lead to skewed income calculations and tax liabilities.

3. COGS only accounts for current costs and cannot predict future performance.

4. COGS is just one metric; thus, investors and analysts cannot rely solely on it for comprehensive decision-making.

Author

Samantha Goddiess

Samantha is a lifelong writer who has been writing professionally for the last six years. After graduating with honors from Greensboro College with a degree in English & Communications, she went on to find work as an in-house copywriter for several companies including Costume Supercenter, and Blueprint Education.