How To Calculate The Cost of Goods Sold
Before you can accurately determine your business’s profits, you must first calculate the cost of goods sold.
Statistics relating to these expenditures are an essential aspect of your business’s finances.
Moreover, knowing this calculation empowers owners to make educated decisions when pricing the merchandise they sell.
Let’s dive straight into what this is and how to calculate the cost of goods sold.
Cost Of Goods Sold: What Exactly Does It Mean?
The cost of goods refers to the amount involved in producing the goods or services you sell. It involves expenditures related to the direct labor and resources used to make the items or services on sale. It strictly applies to products or services that are exchanged for monetary value.
Other indirect expenses such as utilities, shipping fees, and additional overhead charges are left out when calculating COGS.
Let’s say you’re a furniture manufacturer. In this case, your cost of sales is limited to the expenses incurred for the raw materials like wood, glass, paint hinges, and screws. It won’t include indirect fees such as the electricity needed to operate machinery, marketing efforts, and shipping.
The COGS Formula
Finance experts use this formula in accounting to estimate the cost of goods sold for services or items involved over a given period. Here’s how to calculate COGS.
- COGS = (inventory in the beginning + purchases over a period) - inventory at the end
Your inventory at the beginning is full of stock carried over from what was remains after your last sale. In addition to this stock, you’ll add the expenses of everything that you buy over a given period. Finally, subtract the inventory that doesn’t sell at the end of the tenure.
You can span these expenses over one month, a quarter of a year, or several calendar years.
Example Of Cost Of Goods Sold
Suppose your inventory was valued at $5,000 at the start of the calendar year. Over that year, you spent $3,000 on purchases. On the last day of the year, you were left with an inventory valued at $2,000.
You can calculate the cost of goods sold for that said year in the following way.
COGS: ($5,000 + $3,000) - $2,000
Thus, the total cost of services for that calendar year turns out to be $6,000. You’ll then need to compare this amount to the profit you made for the same year. This comparison will show whether you need to pursue different vendors with better prices in the future.
Why You Must Know Your Cost Of Goods Sold
You must know your COGS for the following reasons.
- Set up sustainable prices: Managing prices is one of the most challenging tasks in business. While the right pricing helps you make profits faster, overpricing or underpricing can be extremely detrimental to your company
- Keep tabs on your business’s growth: With COGS figured out, you can proceed to determine the gross profit. This is the money earned before deducting tax and other expenses. After this, you can calculate the final profit that subtracts all included expenses
How To Account For COGS
Now that you know how to find the COGS, where do you record them?
These expenditures generally go on your company’s income statement under sales or revenue. You must deduct this amount from your sales to get the gross profit.
Methods And Costing Changes In COGS
The expense of merchandise sold isn’t static during an accounting period. Instead, it changes with the fluctuating price and the following three inventory valuing methods.
- First in, first out (FIFA)
- Last in, first out (LIFO)
With the first method, you start with a lower COGS. This is because you begin by selling goods you manufactured first, which typically is cheaper than selling recent goods.
The second method requires that you sell your latest items first. This method can give you more significant COGS. The average process is a more level COGS calculation technique that gives you an average for the whole duration.
The Bottom Line
Knowing how to find the cost of goods sold is an ideal place to start understanding your finances. With these simple accounting terms and tricks, you can stay at the top of your game and make an educated financial decision for your company.