For specific advice applicable to your business, please contact a professional. When you run a business that sells any product or service, the cost of goods sold COGS is an essential metric.
Cost of goods sold is a major input in overall profitability, so understanding how COGS works and flows into your business results is vital for any business owner or manager.
If you want to know how cost of goods sold works, take a look at the cost of goods formula and learn how you can put cost of goods sold to work to help improve your long-term business outcomes. Cost of goods sold is the total amount your business paid as a cost directly related to the sale of products. Depending on your business, that may include products purchased for resale, raw materials, packaging, and direct labor related to producing or selling the good.
In other words, the materials that go into the product and the labor that goes into making each unit may be included in cost of goods sold. If you incur sales costs specific to that item, like commissions, those costs may also be included in COGS.
Subtracting COGS from revenue gives gross profit, which reveals the core essence of business viability: What are my costs to make a product, and how much do I sell it for? Properly calculating COGS shows a business manager the true cost of the products sold. This is critical when setting customer pricing to ensure an adequate profit margin.
In addition, COGS is used to calculate several other important business management metrics. For example, inventory turnover—a sales productivity metrics indicating how frequently a company replaces its inventory—relies on COGS.
Because a COGS calculation has so many moving parts, it can be prone to errors and subject to manipulation. It can also result in misstated net income and tax liability. At the very least, this can lead to wasted time and lost opportunities. At worst, there can be ethical and legal implications. Businesses that hold physical inventory—such as manufacturers, retailers and distributors—are required to calculate COGS when determining their taxable income.
This tax calculation of COGS includes both direct costs and parts of the indirect costs for certain production or resale activities as defined by the uniform capitalization rules.
Indirect costs to be included for tax purposes include rent, interest, taxes, storage, purchasing, processing, repackaging, handling and administration. Calculating COGS can be challenging.
It requires a company to keep complete and accurate records for the GAAP calculations reported on financial statements and, separately, to support a tax return.
Purchases and production costs must be tracked during the year. All of the above can become exponentially more complicated when volumes and product lines increase.
Calculating COGS can be challenging, especially as the business becomes more complex; an accounting system integrated with inventory management software can reduce the effort required and ensure accuracy. Ending inventory is the value of inventory at the end of the year.
This formula shows the cost of products produced and sold over the year, according to The Balance. This free cost of goods sold calculator will help you do this calculation easily. Cost of goods made or bought is adjusted according to change in inventory. For example, if units are made or bought but inventory rises by 50 units, then the cost of units is cost of goods sold.
If inventory decreases by 50 units, the cost of units is cost of goods sold. Cost of goods sold is also used to calculate inventory turnover, a ratio that shows how many times a business sells and replaces its inventory. COGS is also used to calculate gross margin. The price to make or buy a product to resell can vary during the year. This change needs to be dealt with in a way that satisfies the IRS.
There are three methods:. An e-commerce site sells fine jewelry. To find cost of goods sold, a company must find the value of its inventory at the beginning of the year, which is really the value of inventory at the end of the previous year. Over time, the net income tends to decrease. The average price of all the goods in stock, regardless of purchase date, is used to value the goods sold.
Taking the average product cost over a time period has a smoothing effect that prevents COGS from being highly impacted by extreme costs of one or more acquisitions or purchases. The special identification method uses the specific cost of each unit if merchandise also called inventory or goods to calculate the ending inventory and COGS for each period. In this method, a business knows precisely which item was sold and the exact cost. Further, this method is typically used in industries that sell unique items like cars, real estate, and rare and precious jewels.
Many service companies do not have any cost of goods sold at all. Not only do service companies have no goods to sell, but purely service companies also do not have inventories. If COGS is not listed on the income statement, no deduction can be applied for those costs. Examples of pure service companies include accounting firms, law offices, real estate appraisers, business consultants, professional dancers, etc.
Even though all of these industries have business expenses and normally spend money to provide their services, they do not list COGS. Instead, they have what is called "cost of services," which does not count towards a COGS deduction. Costs of revenue exist for ongoing contract services that can include raw materials, direct labor, shipping costs, and commissions paid to sales employees.
These items cannot be claimed as COGS without a physically produced product to sell, however. These include doctors, lawyers, carpenters, and painters.
Many service-based companies have some products to sell. For example, airlines and hotels are primarily providers of services such as transport and lodging, respectively, yet they also sell gifts, food, beverages, and other items.
These items are definitely considered goods, and these companies certainly have inventories of such goods. Both of these industries can list COGS on their income statements and claim them for tax purposes.
Both operating expenses and cost of goods sold COGS are expenditures that companies incur with running their business. However, the expenses are segregated on the income statement. Examples of operating expenses include the following:. COGS can easily be manipulated by accountants or managers looking to cook the books.
It can be altered by:. When inventory is artificially inflated, COGS will be under-reported which, in turn, will lead to higher than the actual gross profit margin, and hence, an inflated net income. By contrast, fixed costs such as managerial salaries, rent, and utilities are not included in COGS. Inventory is a particularly important component of COGS, and accounting rules permit several different approaches for how to include it in the calculation.
COGS does not include salaries and other general and administrative expenses. However, certain types of labor costs can be included in COGS, provided that they can be directly associated with specific sales.
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