The cost of goods sold tells you how much it cost the business to buy or make the products it sells. This cost is calculated for tax purposes and can also help determine how profitable a business is. The COGS calculation process allows you to deduct all the costs of the products you sell, whether you manufacture them or buy and re-sell them. List all costs, including cost of labor, cost of materials and supplies, and other costs. Check with your tax professional before you make any decisions about cash vs. accrual accounting.
- Cost of goods sold (COGS) may be one of the most important accounting terms for business leaders to know.
- Instead, these are reflected in the inventory on hand at the end of the period.
- In accounting, the cost of goods sold is critical for determining the profitability of a company, department or product line.
- In practice, however, companies often don’t know exactly which units of inventory were sold.
It’s important to keep track of all your inventory at the start and end of each year. However you manage it, knowing your COGS is critical to achieving and sustaining profitability, so it’s important to understand its components and calculate it correctly. COGS also reveals the true cost of a company’s products, which is important when setting pricing to yield strong unit margins. COGS is also used to determine gross profit, which is another metric that managers, investors and lenders may use to gauge the efficiency of a company’s production processes. Logically, all nonoperating costs, such as interest and capital expenditures, are excluded from COGS, too. COGS, sometimes called “cost of sales,” is reported on a company’s income statement, right beneath the revenue line.
Step 6: Do the COGS Calculation
This amount includes the cost of the materials and labor directly used to create the good. It excludes indirect expenses, such as distribution costs and sales force costs. COGS usually takes into account all direct and indirect costs of a product. If you’re in manufacturing you would need to include things like materials and labor, for example.
A low number will show you’re selling slowly and/or have too much inventory. A high number shows you sell products quickly, which is usually positive, but you could also be at risk of stockouts. Here, it is assumed that the items which are bought or manufactured last are sold first.
Are there things you can do to reduce your COGS?
COGS measures how much you spent on goods your business sold, but does not account for overhead expenses, such as marketing costs. When inventory is artificially inflated, COGS will be under-reported which, in turn, will lead to a higher-than-actual gross profit margin, and hence, an inflated net income. LIFO is where the latest goods added to the inventory are sold first.
Operating expenses the expenses that aren’t directly tied to creating the product. To understand the difference between operating expenses and the costs of good solds, you must take into account how you attribute said costs. Its usually used to highlight the sales revenue percentage used by businesses to pay for those expenses that directly vary with sales. The Internal Revenue Service (IRS) requires businesses with inventory to account for it by using the accrual accounting method. You most likely will need a tax professional to calculate COGS for your business income tax return.
How Does Inventory Affect COGS?
Facilities costs (for buildings and other locations) are the most difficult to determine. You must set a percentage of your facility costs (rent or mortgage interest, utilities, and other costs) to each product for the accounting period in question (usually a year, for tax purposes). Whatever inventory valuation method you choose, it’s important to stick to it consistently. It’s also important to ensure that, where relevant, depreciation and amortisation are calculated accurately and that obsolete inventory is written off appropriately. So, while COGS is an important metric, it’s far from an accurate reflection of a company’s total cost of doing business. And, while it’s often listed first on a company’s income or cash flow statement, in reality there are other costs that have to be paid whether a company has any sales or not.
- Cost of revenue is most often used by service businesses, although some manufacturers and retailers use it as well.
- When prices are rising, goods with higher costs are sold first and closing inventory is lower.
- Cost of goods sold is a company’s direct cost of inventory sold during a particular period.
- COGS only applies to those costs directly related to producing goods intended for sale.
- This method is best for perishables and products with a short shelf life.
If your business does COGS calculations annually, then the beginning inventory of every year should be the same as last year’s ending inventory. At this point, you have all the information you need to do the COGS calculation. You can do it on a spreadsheet or have your tax professional help you.
How do you calculate the COGS?
Find out how GoCardless can help you with ad hoc payments or recurring payments. COGS is also an important element for maximizing your business’s tax deductions. Ordinary and necessary business expenses are considered part of COGS and can usually reduce a business’s tax liability. For example, COGS for an automaker would include the material costs for the parts that go into making the car plus the labor costs used to put the car together.