How to Calculate Cost of Goods Sold?

Introduction 

In case your small business deals with tangible goods, you may have probably come across the expression "Cost of Goods Sold" (or "COGS"). You can write off the costs you paid for manufacturing or obtaining the goods you sold using the correct COGS calculation. Usually, the cost of goods is displayed in the profit and loss statement of the business. Tax filings are also likely important as they help you receive tax deductions.

Finding COGS is mainly used to determine the "true cost" of the goods sold during the period. The cost of items bought during the period but either maintained in inventory or not sold is not included in the calculation. All expenses related to making the products or rendering the services the business offers are included in the cost of goods sold. When it comes to commodities, these expenses could consist of labour and raw material costs, which are variable throughout the manufacturing process. 

Based on the applicable accounting rules, COGS might also consist of fixed expenses like manufacturing overhead, storage costs, and occasionally depreciation expenditures. Advertising and management salaries are examples of broad selling expenses not included in COGS. These expenses will be included below the gross profit line in the selling, general, and administrative (SG&A) expense section.

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What is COGS?

The overall cost incurred in producing or purchasing goods sold during the reporting period is known as the Cost of Goods Sold, or COGS. That covers the price of direct labour as well as raw materials. It can also include overhead expenses directly related to the operations that generate profits for you, such as utilities for a manufacturing facility.

Regarding goods, COGS typically consists of the value of the existing inventory and any associated materials and direct labour expenses paid during the year. It may also include the packaging price and shipping to the final destination. Direct labour costs, direct manufacturing overheads, and material costs are all included in the cost of goods sold (COGS), directly proportional to revenue. More resources are needed to produce the goods or services as revenue rises. COGS often appears on the income statement as the second line item, immediately following sales revenue. Gross profit is the result of subtracting COGS from revenue.

Service sectors employ the concept of cost of revenue, whereas only product-making enterprises, including those that produce digital commodities, can use the cost of goods sold. Nevertheless, a lot of businesses may require both to some extent. For instance, a business might provide customers with its goods with a paid support service. In the same way, a lot of service providers also have a product line.

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How To Calculate COGS

COGS=Beginning Inventory+P−Ending Inventory
Where, P=Purchases during the period

Only expenses directly related to generating that income are included in COGS, such as inventory held by the business or labour expenses linked to particular sales. On the other hand, fixed costs like utilities, rent, and management salaries are not included in COGS. Among COGS, inventory is a crucial component. Sold inventory is included in the revenue statement in the COGS account. The stock that remains from the previous year, or the goods that were not sold, is the opening inventory for the following year.

It goes without saying that if you handle your own manufacturing, the COGS formula also becomes a little more complicated. A manufacturing or retail company's opening inventory is increased by any new productions or purchases made. The unsold products at the end of the year are deducted from the sum of opening inventory and additional purchases. The final number derived from the calculation is the cost of goods sold for the year.

The method a corporation uses for inventory costing determines the value of the cost of products sold. A business can record the amount of inventory sold during a certain period using one of three methods: the average cost approach, last in, first out (LIFO), or first in, first out (FIFO). 

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How Is Determining COGS Helpful To Our Business?

Calculating and knowing COGS is fundamental for effective financial management, decision-making, and overall business success. It provides valuable insights into a company's operational efficiency, profitability, and financial position. Here are some reasons why COGS is important -

• For tax purposes, the cost of goods sold is significant. It represents the entire amount you paid to deliver your goods to a consumer—a deductible expense for businesses. Hence, it helps reduce taxable income on your Form 1120. Your small business tax liability will decrease as you incorporate more eligible items in your COGS calculation.

• Additionally, your COGS can reveal a great deal about the overall health of your small firm. After deducting COGS from revenue, what remains is gross profit - revenue minus the cost of sales. Using this figure, you may compute gross margin—the amount of money you make from each product you sell.

One of the most valuable metrics is your gross margin; it will inform you whether your production costs are too high or if your pricing is too low. That is sufficient justification for calculating COGS.

• Businesses can measure inventory turnover, optimise inventory ordering (lower ordering costs), and minimise inventory holding costs, in addition to cutting wholesale expenses by tracking COGS.

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Conclusion

COGS is a crucial indicator of a business's direct expenses. Still, managers must be aware of indirect expenditures like overhead, employee wages for back offices, marketing expenses, and office supplies.

Your inventory costing and COGS calculation will improve if your bookkeeping and records are more accessible. Additionally, keeping accurate records will simplify identifying additional tax deductions for your return.

Furthermore, regular financial reports—income statements, cash flow statements, and balance sheets—allow you to monitor the state of your business. Our bookkeeping accounting software, Inkle Books, is the perfect option if accounting isn't your strong suit and you need assistance. 

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