Whether it's cupcakes, T-shirts, or lawn care equipment, if your business sells products, it's important that you know how to calculate the cost of goods sold (COGS). The COGS is a calculation representing all the costs required to manufacture and sell your products. Your COGS calculation allows you to determine the value of your business inventory - the physical products you sell. Inventory is a business asset and adds value to your company, so it's important to account for it accurately.

There's a set formula for calculating the cost of goods sold. While it might seem complicated at first, you don't have to be a professional bookkeeper or an accountant to master it. Skynova has practical accounting software that can help you calculate, organize, and keep track of important financial statements, from balance sheets to accounts receivable.

Below, we provide more details on why the COGS is so important and provide a step-by-step guide on how to calculate it.

What Is the Cost of Goods Sold (COGS)?

The COGS deals with labor and material costs needed to produce, manufacture, and sell goods. The figure represents the expenses required in a set accounting period to manufacture and sell your products (goods). You will often see the COGS on a business's income statement. The figure is needed to calculate a business's gross income and determine its profitability.

Keeping the COGS low can help ensure a positive bottom line. Let's say you're an online T-shirt retailer, for instance. In January 2020, you sold 1,000 T-shirts with pricing set at $10 per unit, which means you brought in $10,000. Sounds good, right? In fact, that isn't how much you actually earned. To know what you earned per unit (i.e., per T-shirt) sold, you also have to factor in the COGS:

  • If each T-shirt costs $5 to make, you would be earning just $5 per T-shirt rather than $10. That means the $10,000 gets cut in half, down to $5,000.
  • If you find a cheaper manufacturer, each T-shirt might cost just $3 to make. In this case, you're earning $7 per T-shirt. That means you brought in $7,000.

This is a very basic example and is meant to give you an idea of why it's important to consider the cost of goods sold in your business accounting. Calculating COGS is more complicated. Read on to find out how it's done.

What's Included in the Cost of Goods Sold (COGS)?

The COGS is calculated for set accounting periods (e.g., monthly, quarterly, and annually). Only costs directly tied to the production of your business's goods are included in the COGS measure. In the case of the T-shirt example, this might include the cost of labor (e.g., paying people to sew and print the T-shirts), materials (e.g., fabric and thread), and manufacturing overhead (e.g., the cost of electricity to run your sewing machines and printing presses).

Here is an overview of the points factored into a COGS equation:

  • The cost of raw materials needed to make the product
  • The cost of parts needed to make the product
  • Direct labor costs
  • The cost of supplies used to make or sell the product
  • Overhead costs related to manufacturing, like utilities for the production site
  • Shipping, freight, and/or container costs
  • Indirect business expenses, like distribution or sales force costs
  • The cost of any items acquired and intended for resale

Calculating the Cost of Goods Sold (COGS)

The formula to calculate the cost of goods sold (COGS) is fairly straightforward. However, each element of the formula requires its own data and calculations. Don't worry: we'll walk you through each step. First, here is the basic COGS formula:

Beginning Inventory
+ Purchases During Period
− Ending Inventory
= Cost of Goods Sold (COGS)

Skynova's accounting software can help you calculate the cost of goods sold easily and efficiently. You can also use it to help with the individual steps below.

Step 1: Gather COGS Calculation Information

You will need some preliminary information before you can start working on your business's COGS formula. An accounting method and inventory cost method are two critical components to figure out first to complete your COGS calculation.

Accrual Accounting Method

The Internal Revenue Service (IRS) requires inventory-based businesses to account for their inventory using the accrual accounting method. Accrual accounting is a way of recording income and expenses. With this model, you record income after you've sent your customer the bill for the product (even if you haven't been paid) and record expenses as soon as you receive the bill (even if you haven't paid yet).

There is an exception to this rule for small businesses. If your annual gross receipts for the last three years total $26 million or less, you may opt out of keeping an inventory and using the accrual accounting method. If you choose to take advantage of this exception, consult a tax professional. They can confirm that you're eligible and advise on what paperwork you need to file.

Inventory Cost Methods: LIFO or FIFO

The IRS allows several different methods depending on the type of inventory your business has. The FIFO method and LIFO method are two popular inventory costing methods.

  • First in, first out (FIFO): With the FIFO model, the assumption is that the oldest inventory is sold first. This allows for a lower cost of inventory since older items are usually less.
  • Last in, first out (LIFO): Under the LIFO method, it's assumed that the newest inventory is sold first. This results in a higher inventory total cost.

Step 2: Determine Direct and Indirect Costs

Direct costs are expenses directly related to the purchase or production of the goods you sell. Indirect costs are expenses related to processes around manufacturing or purchasing, like warehousing, equipment, and labor. To complete your COGS formula, you have to differentiate between the two.

Let's return to the example of the T-shirt company. Your direct costs might include money paid to workers who make the T-shirts, from those who sew the basic clothing to those who embroider the decorative finishes. Indirect costs could include fees for storing the T-shirts and labor fees for people who work in the warehouse doing jobs like packing, stocking, and shipping (but not actual production).

Step 3: Calculate Facilities Costs

Facilities costs might include the rent or mortgage on your business, warehousing, and facilities properties and the cost of keeping these properties operational. Facilities operating expenses include utilities like power and water. You must calculate a percentage of your facilities costs for every good you sell. Determining facilities costs can be tricky, and you may want to consult an income tax professional at this point.

Step 4: Determine the Value of Your Beginning Inventory

Inventory includes raw materials, works in progress, merchandise in stock, and finished products. You should keep running inventory throughout the year, physically counting and tracking every item that goes into the manufacturing of your product. Your beginning inventory refers to the inventory value you have at the beginning of the year (which must match the closing inventory of the previous year - if it doesn't, you'll have to explain this discrepancy to the IRS).

Step 5: Add Additional Inventory

You will likely add inventory throughout the year. Again, you must track every piece of inventory, including additions and their shipping and manufacturing costs. Keep the invoices and paperwork related to any new inventory you acquire or produce. If you add items you make to your inventory, consult a tax professional to determine what percentage cost to add to your inventory.

Step 6: Calculate the Value of Ending Inventory

The ending inventory is what you have left at the end of the year. This will require physically taking an inventory of each product. The overall value of your ending inventory may decrease if it's damaged, destroyed, or obsolete (for example, nobody is going to buy a 2020 calendar in 2021). Note that you have to provide evidence of the inventory's depreciation to the IRS.

Step 7: Complete the Cost of Goods Sold Formula

Once you've completed the steps above, you can put the COGS formula into action. As a refresher, here's the formula:

Beginning Inventory
+ Purchases During Period
− Ending Inventory
= Cost of Goods Sold (COGS)

So, you have your "Beginning Inventory" from Step 4, your "Purchases During Period" from Step 5, and your "Ending Inventory" from Step 7.

Let Skynova Help You Determine Your Gross Profit

Calculating the cost of goods sold might be intimidating if you've never done it before. Skynova's accounting software will simplify and streamline your COGS calculations. Our software is designed to take the stress out of business accounting. Check out our offerings to see how you can benefit.