If you sell products, you need to know your cost of goods sold. Also known as cost of sales, knowing your cost of goods sold (COGS) can help you price products correctly.
This information can also alert you if you’re overspending on products or materials, and allows you to make proactive adjustments to increase your net profit. As an added bonus, your financial statements will accurately reflect the true cost of selling your products.
Overview: What is cost of goods sold (COGS)?
Knowing your COGS is a must for anyone selling products, whether you manufacture products in-house or purchase them for resale. It’s impossible to know how much money you’re making on the goods and services you sell if you don’t calculate your cost of goods sold.
Your cost of goods sold tells you a lot about your business, including the following:
- How much profit you’re making on each product
- If your product pricing is too high or too low
- Whether you need to find another vendor or supplier
- If you should continue to sell the product at all
For instance, if you currently purchase rocking chairs from a vendor for resale, your cost of goods sold reflects the cost of purchasing the chairs from your vendor, including freight costs.
If you manufacture the rocking chairs yourself, you need to include the cost of materials needed to manufacture the rocking chairs such as wood, nails, varnish, and paint. You’ll also need to include the direct labor cost of producing the chairs, as they can’t be sold unless they are assembled.
Once you calculate your cost of goods sold, either manually or by using accounting software, the total will be reported on your income statement.
The cost of goods sold formula
For retailers, the cost of goods sold accounting formula is simple:
Beginning Inventory + Inventory Purchases for the Period – Ending Inventory = COGS
If you manufacture products, you will also need to add direct labor costs to the formula:
Beginning Inventory + Inventory Purchases for the Period + Direct Labor Cost – Ending Inventory = COGS
How to calculate cost of goods sold (COGS)
If you’re using accounting software with a good inventory management system or point of sale (POS) module, most of these calculations will be completed automatically.
If not, you or your bookkeeper will need to track inventory and all associated costs separately in order to accurately calculate the value of your inventory and your cost of goods sold.
To calculate the cost of goods sold for a small retail store, let’s use the following example:
Anthony owns a small retail store that sells children’s books. He purchases the books from several distributors, all with different pricing.
He doesn’t need to repackage the books, but he does need to account for the freight cost to receive the books from his distributors as well as the cost of materials used to ship books to his customers. Here are the steps Anthony needs to take to calculate his COGS.
1. Calculate beginning inventory
Find your beginning inventory amount for the period you are calculating COGS for. If you’re calculating for the calendar year, you’ll use your beginning inventory as of January 1 on your balance sheet.
If you’re calculating for the month, find the beginning inventory amount on your balance sheet for the month. In Anthony’s case, the value of his beginning inventory as of May 1 was $61,000, which included freight costs.
2. Add inventory purchases for the period
On May 13, Anthony purchased more books. The total purchase was $9,400. Because Anthony uses accounting software, he can account for that purchase, including any related freight costs, by directly receiving the new books into inventory.
3. Labor costs
If Anthony needed to repurpose the books, or was manufacturing the books in-house, he would need to include the wages of his employees responsible for creating or repurposing the books.
Because he buys them directly from a distributor, he does not have to include any labor costs when calculating his cost of goods sold.
4. Subtract ending inventory
As of May 31, Anthony’s inventory total is $47,000. Anthony uses accounting software, so this amount is calculated for him. If he weren’t, he would need to count the number of books left in inventory at month end, and assign a value to them in order to properly calculate his cost of goods sold.
5. Calculate cost of goods sold
Anthony’s cost of goods sold would be calculated using the COGS formula shown above:
$61,000 + $9,400 – $47,000 = $23,400.
That means that for the month of May, Anthony’s cost of goods sold was $23,400. If Anthony were manufacturing the books, he would need to include direct labor cost in his cost of goods sold calculation.
Cost of goods sold can change frequently
The most important way to ensure that your cost of goods sold is calculated accurately is by choosing an inventory accounting method that suits your business. You can choose from three inventory costing methods:
- FIFO: The FIFO method (first in, first out) means that you sell the inventory you purchased first. In many cases the inventory purchased first is also the least expensive, which results in a lower cost of goods sold.
- LIFO: The LIFO (last in, first out) method means that you sell the most recently purchased products first. Because the most recently purchased products can also be the more expensive products, the LIFO method will likely increase your cost of goods sold.
- Weighted Average: The weighted average inventory cost method can be helpful if you purchase the same product from multiple suppliers or distributors. To calculate the weighted average, you would take the current inventory value and divide it by the number of products available. For example, if Anthony’s ending inventory was valued at $47,000 and he had 7,500 books left in inventory, he could find his weighted average using this calculation:
$47,000 ÷ 7,500 = $6.26.
Whether you’re calculating your gross margin ratio or trying to determine best pricing for your products, determining your cost of goods sold is an important task and a vital part of the small business accounting process.
The final cost of your goods sold will always depend on the inventory accounting method you’re using.
Of course, the best way to manage the cost of goods sold is by using accounting tools made for small businesses such as small business accounting software.
If you’re in the market for an accounting software application that can calculate your cost of goods sold, be sure to check out The Blueprint’s accounting software reviews.
View more information: https://www.fool.com/the-blueprint/cost-of-goods-sold/