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Cost Of Goods Sold Formula: How To Calculate COGS

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Cost Of Goods Sold Formula: How To Calculate COGS

Retailers need to track the cost of goods sold (COGS) to ensure profitability and report expenses to the IRS correctly. However, considering that many small business owners lack enough knowledge about accounting and finance, it’s a good idea to understand how COGS can impact sales and tax liability. 

While the COGS formula might look technical initially, this guide will walk you through what’s included in COGS, how to calculate it, and different ways to help prepare for tax season.

What is the cost of goods sold?

Cost of goods sold (COGS) is the direct cost of producing products your business sells. Also referred to as “cost of sales,” COGS includes the cost of materials and labor directly related to the production and manufacturing of retail products. 

Why cost of goods sold is important

The COGS formula is important for any retail business because it helps: 

  • Determine profitability. COGS directly affects your profit margins. The calculation helps you determine the profit you make on each sale, understand which products are most profitable, and help you set the best price.
  • Optimize inventory. With an efficient system, you can reduce storage costs and minimize wastage, reducing COGS. This can assist with purchasing, stocking, and production decisions.
  • Keep track of expenses. A product requires materials and parts. Not to mention the fixed costs: the labor, factory overhead, rent, equipment, electricity to run the operations, employees to sell said products in your store, as well as sales, marketing, and finance. These are all expenses that contribute to the end cost of the product—expenses you need to keep track of to ensure that you are making a healthy gross profit and that you can accurately price products and keep healthy margins.
  • Manage tax liability. The IRS allows you to deduct the cost of goods used to make or purchase the goods you sell in your business. By calculating all business expenses, including COGS, the company ensures they are offsetting them against total revenue come tax season. This means the company will only pay taxes on net income, thereby decreasing the total amount of taxes owed when it comes time to pay taxes.

Bear in mind that while high COGS means a lower income tax, that is not the ideal scenario, because it ultimately also means lower profitability for the company. It’s important to manage COGS efficiently to increase profits.

What’s included in the cost of goods sold calculation?

The cost of goods sold is essentially the wholesale price of each item, which includes the direct labor costs required to produce each product. This includes:

  • The individual costs of all parts used to build or assemble the products
  • The cost of all the raw materials needed for the products
  • The cost of any items purchased for resale and/or to create the product
  • The parts or machines required to create the product
  • All supplies required in the production of the product
  • Shipping parts and equipment to the warehouse to create the product, including containers, freight, and fuel surcharges
  • The people who put the products together and ship the parts

COGS vs. operating expenses

Operating expenses and cost of goods sold are two different expenses that occur in your daily business operations. They are both subtracted from your business’s total sales figures, yet they are recorded as separate line items on your income statement

Operating costs refer to expenditures not directly related to the production of your products. These include:

  • Rent
  • Office supplies
  • Legal costs
  • Sales and marketing
  • Payroll
  • Utilities
  • Insurance

For example, a fashion boutique must pay rent, utilities, and marketing costs no matter how many items it sells in a month. When the boutique sells a shirt, the COGS formula accounts for the sewing, the thread, the hanger, the tags, the packaging, and so on. It also includes any goods bought from suppliers and manufacturers.

How to calculate cost of goods sold

  1. Determine direct vs. indirect costs
  2. Figure out beginning inventory and cost of purchases
  3. Calculate ending inventory 
  4. Apply the cost of goods sold formula

1. Determine direct vs. indirect costs

When calculating the COGS formula, it’s important to remember that each product has two types of costs: direct and indirect.

Direct costs are all costs directly associated with the product itself. This includes: 

  • Raw material costs or items for resale
  • Cost of inventory of the finished products
  • Supplies for the production of the products
  • Packaging costs and work in process
  • Supplies for production
  • Overhead costs, including utilities and rent

Indirect costs include: 

  • Labor, the people who put the product together
  • The equipment used to manufacture the product
  • Depreciation costs of the equipment
  • Costs to store the products
  • Administrative expenses and salaries
  • Non-production equipment for back-office staff

A note on facilities costs: This part is tricky and requires an experienced accountant to accurately assign each product. These costs need to be divided strategically among all the products being manufactured and warehoused, and are usually calculated annually.

2. Figure out beginning inventory and cost of purchases

Whether you sell jam, t-shirts, or digital downloads, you’ll need to know how much inventory you start the year with to calculate the cost of goods sold. Total of all the products purchased during the fiscal year that are available to sell, including raw materials, minus anything taken for personal use.

Beginning inventory doesn’t simply include finished products in stock and ready for resale, but also all the raw materials you have, any items that have been started but not completed, and any supplies. This should match the ending inventory for the previous fiscal year.

Further, whatever items and inventory are purchased throughout the year that don’t fall under the beginning or ending inventory must also be accounted for. These are the cost of purchases and include all items, shipments, manufacturing, etc. As with your taxes, you must keep all paperwork showing these items were purchased during the correct fiscal year.

3. Calculate ending inventory

At the end of the year, it’s important to take stock of all the remaining inventory—this means all products that remain and have not been sold. This information will be used in the current COGS calculation and will also be required for the following year’s calculations.

All ending inventory can be categorized as resale ready, damaged (requires the estimated value of the items damaged), worthless products (evidence of destruction must be provided), and obsolete items (evidence of devaluation needed). For the latter, these products can be donated to charities for a little extra goodwill.

4. Apply the cost of goods sold formula

Once you’ve calculated your inventory at the start and end of your reporting period, here is the accepted COGS formula used by accountants: (Beginning Inventory + Purchases) – Ending Inventory = COGS.

COGS = (beginning inventory + purchases) — ending inventory.
Here’s the COGS formula you can use to calculate the cost of goods sold.

???? PRO TIP: Shopify makes it easy to find your cost of goods sold at the end of your calendar year—no manual calculations or formulas required. To get started, go to the Finances summary report from your Shopify Admin and select the time period you want the report to reflect.

Cost of goods sold formula example

Say your company has the following information for recording the inventory for the calendar year ending on December 31, 2022. Your inventory at the beginning of the year is $20,000. At the end of the year, your ending inventory is $6,000. During the year, your company made $8,000 worth of purchases throughout the reporting period. 

You can calculate COGS using the formula above: ($20,000 + $8,000) – $6,000, making your COGS $22,000.

Accounting methods for the COGS formula

Whoever prepares your taxes should advise you on what inventory accounting method you should use for your business. The most popular methods are: 

  • Weighted average cost
  • First in, first out
  • Last in, first out

Weighted average cost

Inventory weighted average, or weighted average cost method, is one of the three most common inventory valuation methods. It uses a weighted average to figure out the amount of money that goes into COGS and inventory.

In this method, the average price of all products in stock is used to value the goods sold, regardless of purchase date. It’s an ideal method for mass-produced items, such as water bottles or nails. 

Take the following inventory buys, for example:

  • 200 units at $5 each
  • 100 units at $6 each
  • 150 units at $5.50 each

Your total inventory would be $2,425. Your average cost per unit would be the total inventory ($2,425) divided by the total number of units (450). That’s $5.39 per unit. 

To find the weighted average cost COGS, multiply the units sold by the average cost. If you sold 100 units, your weighted average cost would be $539. 

First in, first out

First in, first out, or FIFO, is an assessment management method where assets produced or purchased first are sold first. This method is best for perishables and products with a short shelf life. 

For example, say you bought units X, Y, and Z and received two orders for one unit each. Using FIFO, your first order is $5 because you bought unit X first and paid $5 for it. Assuming the first order depletes unit X, the COGS on your second order is $6 because that was what you paid for the next unit you bought. 

When prices rise, higher-cost goods are sold first, and the closing inventory is higher. This results in higher net income over time. When prices are decreasing, the opposite is true. 

Last in, first out

Last in, first out (LIFO) is the opposite of FIFO. It assumes the goods you purchased or produced last are the first items you sold. When prices rise, goods with higher costs are sold first, and the closing inventory is lower. This results in a decreasing net income. 

Using the example above, your LIFO COGS for the first order would be $5.50 because you bought unit Z last. The COGS on your second order would be $6 because the next unit you bought was Y. 

During times of inflation, LIFO leads to a higher reported COGS on your financial statements and lower taxable income.

Use the COGS formula for your retail store

Whether you’re opening your first retail store or your fifth, the accounting process is tough. Business owners can’t control the price of each other’s suppliers. But what you can control is the accounting methods you use to track metrics like COGS. 

Be thorough in your accounting practices. Partnering with a good accountant can improve your small business, not just by taking the headache out of tax preparation and COGS formulas, but by providing financial advice that improves your bottom line.

Take the stress out of sales tax with Shopify Tax

With Shopify Tax, you can oversee your current sales tax obligations from Shopify admin, collect the right amount at checkout with product and location-specific accuracy, and let Shopify automatically apply rate and regulatory changes whenever they happen.

Explore Shopify Tax

Costs of goods sold (COGS) FAQ

What is the meaning of COGS?

Cost of goods sold refers to the amount of money that goes directly into creating a product. The cost of things like raw materials, factory labor, and factory overheads. It does not include things like marketing, sales, or distribution.

Who uses the cost of goods sold?

Service companies don’t have a COGS, and cost of goods sold isn’t addressed in generally accepted accounting principles. It’s only defined as the cost of inventory items sold during an accounting period, hence why it’s mainly used by ecommerce businesses and retail stores.

How do you calculate the cost of goods sold?

Here is the accepted COGS formula used by accountants: (Beginning Inventory + Purchases) – Ending Inventory = COGS.

What is included in the COGS?

The COGS formula includes any cost associated with producing products sold by a company. This includes labor that is involved in physically creating the product (not selling it), raw materials to create the product, the cost of shipping in raw materials, and storage costs.

How is COGS shown in the balance sheet?

COGS is included on an income statement as the second line item after total revenue. It is subtracted from that revenue to calculate the gross profit a company has made.

Is COGS a revenue or expense?

COGS is considered a business expense. It’s all the money spent to buy goods or physically produce them like labor costs, raw materials, and factory overhead.

This article originally appeared on Shopify Retail Blog and is available here for further discovery.
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