INVENTORY MANAGEMENT   |   4 minute read

How to Calculate COGS and Why It Matters for Your Small Business

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.

How to calculate your COGS

Before you calculate COGS, you need to define a costing method to put a cost on ending inventory. You have three choices:

  1. First in, first out (FIFO): The first item added to inventory is the first item sold. As long as prices are rising, using FIFO will minimize COGS and maximizes profits and taxes.
  2. Last in, first out (LIFO): The last (and usually the most expensive) unit added to inventory is the first item sold. This maximizes COGS and minimizes profits and taxes. However, LIFO isn’t typically practiced outside of the United States.

Average cost: Costs are averaged regardless of purchase or production date. This will level out COGS, profits and taxes.

Related Blog: The inventory value of your stock: making sense of FIFO, LIFO and WAC

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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)
- Ending Inventory (unsold inventory at the end of the year)
= Cost of Goods Sold 

Why you should care about COGS

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

3 reasons why it’s important to know your COGS

  1. Product pricing:
    If you know your cost of goods sold, you can set product prices that leave you a healthy profit margin. COGS can also help you determine when prices on a particular product need to go up.

    For example, if Intergalactic eCommerce Corp.’s cost of goods sold for Spacesuit X equals $120,000, you need to price the product higher than $120,000 to turn a profit.

  2. The government:
    Uncle Sam (or your local government equivalent) wants to know how much a business made so it can tax the business accordingly.

    Because COGS are categorized as business expenses–meaning, it doesn’t count towards your gross revenue–your business can offset them against total revenue when tax season comes. Your company will only pay taxes on the net income, thereby decreasing the total amount of taxes owed.

    For sole proprietors and single-member LLCs using Schedule C, cost of goods sold is calculated in Part III and included in the income section (Part I).

    For partnerships, multiple-member LLCs, corporations and S corporations, cost of goods sold is calculated on Form 1125-A. This form can be complicated, so it’s best to recruit the help of a tax professional to help you with it. 

  3. Opportunities for the future:
    By keeping track of your costs of goods sold, you can identify areas of opportunities for improvement and growth, or to stop producing altogether.TG_dashboard

Additional tips for calculating COGS

  • You can only deduct COGS if you have sales. If you purchase or make products to sell, and you don't sell any products, you can't deduct these costs.
  • If your business has less than $1 million in sales / receipts annually, you do not need to report inventory.

Are you tracking the numbers and data you need to compute your cost of goods sold? TradeGecko makes it easy to record your business expenses by integrating with best-in-class accounting software.

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