Before calculating your business’ profits, you need to know your Cost of Goods Sold (COGS). The Cost of Goods Sold – also referred to as cost of sales or cost of services – measures the direct costs incurred in creating your product or services. It does not include indirect expenses such as overhead, distribution, storage or marketing costs.
There are lots of hidden costs associated with the production of your goods or services. The good news is, calculating your COGS will not only help you see the full picture of your revenue, those costs are also tax deductible.
Before you calculate COGS, you need to define a costing method to put a cost on ending inventory. You have three choices:
Average cost: Costs are averaged regardless of purchase or production date. This will level out COGS, profits and taxes.
Here’s an example that illustrates the COGS calculation:
Intergalactic eCommerce Corp. manufactures sophisticated space travel gear. The balance sheet dated Dec. 31, 2017 puts ending inventory cost at $12.5 million. During the year, Intergalactic purchases $10 million of raw parts and related supplies, and applies another $20 million in labor. This creates additional inventory valued at $30 million using the average cost method. The ending inventory on Dec. 31, 2018 is physically counted and valued at $5 million.
To calculate COGS:
COGS = Beginning inventory + Additional Inventory Costs - Ending Inventory
COGS is $37.5 million = $12.5 million + $40 million - $5 million
Beginning Inventory (inventory leftover from the previous period)
+ Additional Inventory Costs (inventory purchased during the year)
Knowing this number can help you make decisions, such as finding vendors with better direct material prices.
Knowing your COGS can also help you calculate your business’ gross profit for the period.
For example, let’s say you have revenues of $120,000. Subtract your COGS of $8,000 from $120,000. Your gross profit is $112,000 for the period.
Related blog: Price list management: How to calculate cost price
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