How To Calculate Cost of Goods Sold (With Examples)

When it comes to running a business, the list of expenses to track is endless. You need to know the cost of payroll, marketing, supplies, rent, commissions, and the cost of goods sold, among others.

If you work in management or accounting or run your own business, you have likely come across the term “cost of goods sold.”

If your business carries and sells inventory, you need to calculate the cost of goods sold. Not only is it necessary for financial reporting, but it can also help to evaluate the overall financial success of your company.

Higher COGS equals lower profit margins. The opposite is also true. Lower COGS equals higher profit margins.

What Is the Cost of Goods Sold (COGS)?

The cost of goods sold, which is often referred to as COGS or cost of sales, is a business expense consisting of the direct costs associated with producing or acquiring the goods sold by a company.

The direct costs included in this calculation are typically direct material costs and direct labor expenses. COGS does not consider indirect expenses like marketing or shipping in its calculations.

All companies who keep inventory and sell products must calculate the cost of goods sold. This should be done during each accounting period. Your accounting period will depend on your business’ preferences and may be monthly, quarterly, or yearly.

Tracking the cost of goods sold is required; it should be one of the items tracked on your business’ income statement. If you’re unfamiliar with the income statement, your company may refer to it as your Profit and Loss Statement or your PL.

Without knowing your COGS, you won’t be able to calculate your business’ profits properly.

Calculating Cost of Goods Sold (COGS)

The formula for calculating COGS is relatively simple:

To calculate your cost of goods sold, you will need first to understand each piece of the COGS formula.

1. Beginning inventory. Your beginning inventory is the inventory value at the beginning of the accounting period or the value of the inventory left over from the previous accounting period.

2. Cost of goods. The cost of goods is the cost of any product bought or made throughout the accounting period. This includes materials and labor.

3. Ending inventory. Your ending inventory is the value of the inventory at the close of the accounting period. Your ending inventory for this accounting period will become the beginning inventory of the next accounting period.

   COGS calculation is just one of the many reasons you should invest time in inventory management.

Why Do You Need to Know COGS?

The cost of goods sold (COGS) is an incredibly important metric for your business. Not only is it important for taxes—it is a deductible expense after all—it is an important part of understanding the overall health of your business.

Properly calculating your cost of goods sold allows you to determine a “true cost.” Once you know the COGS, you can calculate your gross profit.

You deduct COGS from revenue to determine gross profit:

Inventory Costing Methods and COGS

The inventory costing method your company chooses will directly affect the value of the cost of goods sold during each accounting period.

There are three inventory costing methods:

1. First In, First Out (FIFO). As the title implies, the first products acquired during the accounting period will be sold. The cost of materials and labor tends to go up over time, so the idea is to sell the least expensive products first.

   With this method, net income tends to increase over time.

2. Last In, First Out (LIFO). The opposite of FIFO, LIFO sells the most recent products first. Since the cost of materials and labor usually goes up over time, this method focuses on selling the most expensive products first.

   With this method, net income tends to decrease over time.

3. Average Cost. This method doesn’t value purchase or manufacturing dates to determine sales orders. The average cost of each item is calculated to keep the cost of goods level and consistent.

Cost of Goods Sold (COGS) and Your Taxes

COGS is a deductible business expense. The IRS has a detailed explanation of how to calculate your cost of goods sold properly. You must follow the set rules and regulations when calculating and filing. Otherwise, you run the risk of an audit later.

The type of business you run determines where to include COGS on your tax return:

1. Sole proprietors and single-owner LLCs. You will calculate and report your cost of goods sold on your Schedule C. The calculations will be included in Part III along with other expenses to determine your net income. Net income will be reported on Line 12 of Part I.

2. C corporations, S corporations, partnerships, and multiple-owner LLCs. You will be using Form 1125-A. This is a more complicated process, so it is recommended that you have a professional handle these calculations.

   • Corporations. The cost of goods sold will be calculated on Form 1125-A. The net income will be reported on Line 2 of Form 1120.

   • S Corporations. The cost of goods sold will be calculated on Form 1125-A. The net income will be reported on Line 2 of Form 1120S.

   • Partnerships and multiple-owner LLCs. The cost of goods sold will be calculated on Form 1125-A. The net profit will be reported on Line 2 of Form 1065.

Service-Based Companies and Cost of Goods Sold

While some companies that deal in services do offer products, many have no inventory at all. Without inventory or goods sold, COGS cannot be calculated. So, if no goods are sold, a company cannot claim COGS.

They can, however, claim the Cost of Services. Similar to COGS, this focuses on direct costs and ignores indirect costs. For Cost of Services, you will focus on labor costs directly tied to the rendering of services.

Direct Costs vs. Indirect Costs

To properly calculate the cost of goods sold or the cost of service, there needs to be an understanding of what can be included in those calculations.

COGS consists of direct costs only.

Direct costs will be directly tied to a “cost object,” the product or service, and includes costs related to the production or acquisition of that “cost product.”

These costs can be fixed or variable—they can fluctuate. Generally speaking, direct costs include the direct labor expenses and the direct material costs.

Indirect costs include the overhead costs left over after direct costs have been calculated. These operating expenses (OPEX) are not tied directly to a “cost object.”

Materials and labor costs unrelated to the specific products, rent, utilities, office supplies, payroll, insurance, and marketing would all be considered operating expenses or indirect costs.

Like direct costs, these can be either fixed or variable costs. For example, rent would be a fixed cost while utilities would be a variable cost. While rent will occasionally go up, it is usually a consistent set expense each month. Utilities, on the other hand, are dependent on their use.

Cost of Revenue vs. Cost of Goods Sold

While similar, the cost of revenue and cost of goods sold are not the same. Cost of revenue consists of the cost of goods sold (or cost of services) plus any additional costs related to the sale.

In addition to production costs, the cost of revenue also includes costs such as marketing, shipping and distribution, commissions, and discounts applied.

Like the cost of goods sold, the cost of revenue does not include any indirect costs.

Limitations of Cost of Goods Sold (COGS)

This is a required business expense to track. There is no getting around it if you want to file your taxes and properly calculate your profits and expenses. That said, it doesn’t come without a downside or two, or several.

1. It is not difficult to manipulate the COGS numbers. Anyone looking to “cook the books” or falsify information would need only alter the numbers in their favor. They could overstate returns, overvalue inventory, fail to write-off inventory, etc.

2. The calculations for the cost of goods sold can be prone to errors. An incorrect cost of goods—whether from error or manipulation—can skew income calculations and tax liability.

3. The cost of goods sold can’t give any predictions for the future. It simply accounts for current costs.

4. COGS is just one metric. Investors and analysts cannot rely on the cost of goods sold to give them all the information they require to make decisions.

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.