How To Calculate and Record Cost of Goods Sold?

When you start doing business, you learn the depth of each accounting term and its significance in business planning and strategy. One such term is the cost of goods sold (COGS). It is the direct cost incurred to manufacture a good or undertake a service. It is not as simple as it sounds. The confusion comes in identifying the direct cost, which differs for each business. In this article, we will touch upon the concept of COGS and help you calculate it for your business.

What Is the Cost of Goods Sold?

As the name suggests, COGS is all the cost you incur to manufacture that good. It includes any raw materials purchased, labour costs, and commission paid to procure materials/inventory. In accounting terms, it is called the direct cost.

The indirect cost includes the amount spent marketing and distributing the product. Suppose you purchased or rented equipment to make the product. This is called the overhead cost and not the direct cost. The overhead cost comes in indirect cost.

COGS is different for every business. What is a direct cost for you, and may be indirect for the other? A manufacturing company is product-based, and COGS includes raw materials and components costs to make the finished product. For a retailer, COGS would be the cost of finished goods purchased from the manufacturing company plus shipping and handling. For a service company, COGS would be the cost of sale. For instance, a software developer would add the cost incurred on sales activity, HR, and payroll of the operations team as the cost of sales. You should carefully identify which direct and indirect costs are in your business.

Why are we stressing about what is included in COGS? Because COGS is the absolute lowest price, you can charge for your goods and services to break even. After COGS, you price in the overhead cost and then a profit margin to become profitable.

How to Calculate Cost of Goods Sold?

To calculate the cost of goods sold, you must accumulate information such as your opening inventory balance, cost of new inventory purchased, overhead costs (delivery fees, returns, shipping costs), and ending inventory balance.

Next, plug the data in the COGS formula:

Cost of goods sold = (starting inventory + purchases) – ending inventory

Add any labour cost, shipping, and handling fees to the purchase.

Tip: When calculating the inventory, be careful which valuation method you use: LIFO (last in first out) or FIFO (first n first out) method. If you change the methodology, the COGS will change. You will have to change the cost for previous years as well. Apart from valuation methodology, adjust your inventory for any losses due to shrinkage or spoilage.

You can check your COGS calculation by using the ending inventory formula:

‍Ending Inventory = Beginning Inventory + Purchases – COGS

Let’s understand this with an example. James started the month of June with an inventory of $5,000. He purchased $2,000 of goods and paid $100 in shipping and handling charges. At the end of the month, he had $500 worth of inventory.

COGS = Beginning Inventory ($5,000) + Purchases and direct cost ($2,000 + $100) – Ending inventory $500

COGS = $6,600

If we use the ending inventory formula:

$500 = ($5,000+$2,100) – $6,600 

James’s revenue should be at least $6,600 to break even. So, if he sold 100 units, the minimum price per unit should be $66.  

Impact Of Cost of Goods Sold on Your Business

The cost of goods sold impacts the business on three fronts: calculating profitability, determining product pricing, and inventory management.

Calculating profitability: COGS is deducted from the revenue to arrive at the gross profit. If the COGS is high, gross profit falls, which trickles down to net income. Hence, a healthy gross profit margin is considered an efficiency indicator that makes a company comparable with industry standards and other players. When your gross profits are low, reviewing your COGS can help you identify areas where you can save costs without affecting the quality. For low-margin, high-volume businesses like restaurants and groceries, even a tiny reduction in COGS could go a long way.

Determining product pricing: COGS is the starting point for determining the minimum price you cannot sell below. Your COGS might increase due to a surge in raw material prices caused by supply chain issues or inflation. You can adjust your pricing model accordingly.  

Inventory management: You can analyze the trend of COGS to forecast how much inventory is required for that period to maintain optimal levels and improve efficiency.

It is important to calculate the cost of goods sold correctly to stay compliant and arrive at the correct tax rate, as COGS is a tax-deductible expense.

Contact DDL & Co. in the Niagara Region to Help You Prepare the Cost of Goods Sold

Talk to a professional accountant to help you prepare financial statements and accurately calculate your taxes. At DDL & Co., our accountants and bookkeepers can provide services such as preparing books of accounts and filing taxes. To learn more about how DDL & Co. can provide you with the best accounting and bookkeeping expertise, contact us online or call us at 905-680-8669.