How to calculate cost of goods sold
Help ensure your products are priced correctly and avoid overspending on materials with these tips on how to calculate your cost of goods sold. Presented by Chase for Business.
If your business sells products, then it’s important to know how to calculate what these products cost you. Properly calculating the cost of goods sold, also known as COGS, helps you price correctly and deduct your business expenses appropriately for tax purposes.
Monitoring COGS can also make it clear if you’re overspending on material inputs or suppliers and need to make adjustments to ensure profit. Learn how to better understand these costs, why they are important and how to calculate them for your own business.
What is the cost of goods sold (COGS)?
COGS is the amount of money it takes to make your products. The calculation includes any materials and direct labor expenses that go into production. It also includes overhead costs of generating your products or services, such as utilities for your manufacturing facility or your rent.
It’s important to note that COGS calculations are based on products you actually sell and do not include inventory that you have on hand.
Why is it important?
COGS give you important insight into your company’s profits as well as the overall health of your business. This metric is so important because it:
- Determines profitability: You can subtract COGS along with operational costs and other expenses from your gross profits to calculate your net income or net profit.
- Helps you measure your manufacturing efficiency: You can subtract COGS from the total sales revenue to determine gross margins. The more efficient your production, the more gross margin you can earn. If you see gross margins increasing, your products are more valuable.
- Brings attention to operational efficiency: Minimizing COGS is a way to reduce the likelihood of unnecessary expenses like overstocking, product damage and missing inventory.
- Draws awareness to problems: A sudden spike in COGS can indicate that you have a new problem to solve. For example, if you have a theft problem, your inventory will be notably lower than anticipated when you perform your year-end count. An inventory that’s low because of theft will result in a higher COGS and lower profits.
If the costs of making a product are so high that you cannot sell the product at a profit, it’s time to find ways to reduce your COGS or re-evaluate your strategy altogether.
How to calculate the cost of goods sold
It’s time to learn how to calculate it for yourself. Follow these steps to determine COGS for your products. Accounting software can help you with exactly that. It can help you track, analyze and create reports for every area of your business.
1. Calculate all costs related to production
There are both direct and indirect costs.
- Direct costs are the materials, parts, labor and other elements that go into the product your company makes.
- Indirect costs are the equipment, facilities, rent and other expenses it takes to make and ship your product. This also includes your labor costs related to shipping.
For example, if you manufacture picture frames, your direct costs include what you pay for materials, such as metal or paper for inserting stock photos into the frames. The direct labor costs would be for people who operate the machinery to make the picture frames.
Indirect costs would include labor costs for those people who are not directly involved in producing the picture frames but are still necessary, such as shipping personnel.
2. Determine beginning inventory
Your beginning inventory is how much finished product, raw materials and products in progress that you have on hand at the start of an accounting period. On your balance sheet, this number should be the same as your ending inventory from the previous accounting period.
3. Calculate new purchases
Many businesses add more products or purchase materials to increase inventory throughout the year. The total cost of each product you add to your inventory may include additional labor expenses. For example, if you spend $500 on additional materials and $100 on labor costs, your new purchase expenses would add up to $600. If you purchase products wholesale, then the amount you pay for them is the new purchase cost.
4. Determine ending inventory
You can calculate your ending inventory by counting all your physical products or by estimating as closely as you can. As you do this, you can subtract any inventory you were unable to sell due to defects, damage or theft. If you have products or material that were destroyed, you may need to show evidence that this happened. If you have any outdated inventory, you may need to prove that it has decreased in value.
5. Add your data into the COGS formula
You can get the final cost of goods sold by using the following formula:
Beginning inventory + new purchases – ending inventory = cost of goods sold
For example, you had a beginning inventory of $100,000 and you purchased $50,000 of additional materials and products during the year. That leaves you with a total of $150,000 in inventory. After completing your count at the end of the year, you determine that you have $15,000 in products remaining. If you enter that information into the formula, it would be:
$100,000 + $50,000 – $15,000 = $135,000
Because COGS is an expense, you would then subtract this amount from revenue on the income statement.
Strategies to manage changes in inventory costs
Often, businesses find that their COGS is heavily reliant on other industries. For example, let’s say you own a business that manufactures wool socks and you get your wool from New Zealand. If the price of oil goes up substantially, it could become much more expensive to pay for the shipping to obtain the wool for your socks. This would significantly increase your COGS.
Let’s say you have two batches of socks, one from before the spike in oil prices and one from after. The first batch has 200 pairs of socks for $5 each. The second batch has 300 pairs for $10 each. The batch from before the price spike had a COGS of $1,000 and the batch from after the spike had a COGS of $3,000.
Let’s say that you sold 400 pairs from your total inventory of 500 pairs of socks. You could use three different methods to calculate COGS:
- Average cost method: Using this approach, you could simply add the total cost of goods sold, which is $4,000, and divide that by the total number of socks, 500. That would bring the average cost of a pair of socks to $8. That means if you sold 400 pairs of socks, you would have a COGS of $3,200.
- FIFO method: FIFO stands for first-in, first-out. Using this strategy, you would sell the first 200 pairs at a price of $5 each and then the next 200 at a cost of $10 each. That would give you a COGS of $3,000. The benefit of using this strategy, particularly if market prices are driving up costs, is that it keeps your COGS low and profit higher.
- LIFO method: This stands for last-in, first-out. This means that the last pair of socks you received is the first you sell. The problem with this type of inventory approach is that a significant part of your inventory could be very old. The reason some companies use it, though, is because of inflating prices. If you use LIFO, the cost of the newer inventory would always be higher. By calculating the higher-cost inventory into COGS, the company can reduce the reported levels of profitability for tax purposes.
Strategies for controlling the cost of goods sold
Because COGS is crucial to maintaining profitability, it’s important to take steps to optimize it. Here are some strategies you could consider:
- Negotiate deals with suppliers: Suppliers are sometimes willing to work with you on the price of goods, especially if you’re willing to purchase in bulk or sign a long-term contract. Look for ways you could establish a long-term partnership with suppliers to reduce the cost of materials and parts.
- Organize COGS by category: Try developing a system to classify and organize the COGS for specific products or product categories. While this is a bit more labor-intensive, it will provide you with clear insight for how specific products impact your company’s income.
- Consider automation: Consider investing in machines that allow you to reduce the cost of labor or to increase the number of products you’re manufacturing without hiring additional people.
While utilizing strategies to manage the COGS is essential, the better your bookkeeping and records, the easier it will be for you to manage your inventory and calculate COGS. Accounting software can help you with exactly that. It can help you track, analyze and create reports for every area of your business. In addition, managing a business checking account can help you keep track of expenses like inventory, vendors and payroll.
For Informational/Educational Purposes Only: The views expressed in this article may differ from other employees and departments of JPMorgan Chase & Co. Views and strategies described may not be appropriate for everyone, and are not intended as specific advice/recommendation for any individual. You should carefully consider your needs and objectives before making any decisions, and consult the appropriate professional(s). Outlooks and past performance are not guarantees of future results.
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