How to calculate cost of goods sold
Make sure your products are priced correctly and avoid overspending on materials with these tips on how to calculate cost of goods sold. Brought to you by Chase for business.
If your business sells products, it’s important to know how to calculate what those products are costing you. Correctly calculating cost of goods sold, also known as COGS, helps you price correctly and deduct your business expenses appropriately for tax purposes.
COGS monitoring can also make it clear if you are overspending on material inputs or suppliers and need to make adjustments to ensure profits. Learn how to better understand these costs, why they are important, and how to calculate them for your own business.
What is the cost of goods sold (COGS)?
COGS is the amount of money it takes to make your products. The calculation includes all materials and direct labor expenses that go into production. It also includes the overhead costs of generating your products or services, such as utilities for your manufacturing plant or your rent.
It’s important to note that COGS calculations are based on the products you actually sell and do not include inventory you have on hand.
Why is this important?
COGS gives you important insight into the profits of your business as well as the overall health of your business. This metric is so important because it:
● Determines profitability: You can subtract the COGS along with operational costs and other expenses from your gross profits to calculate your net income or net profit.
● Helps you measure your manufacturing efficiency: You can subtract COGS from total revenue to determine gross margins. The more efficient your production, the more gross margin you can earn. If you see an increase in gross margins, your products are more valuable.
● Draws attention to operational efficiency: Minimizing COGS is one way to reduce the likelihood of unnecessary expenses such as overstocking, product damage, and missing inventory.
● Draws awareness to the issues: A sudden spike in COGS may indicate that you have a new problem to resolve. For example, if you have a problem with theft, your inventory will be significantly lower than expected when you do your year-end count. Inventory that is low due to theft will result in higher COGS and lower profits.
If the costs of manufacturing a product are so high that you can’t sell the product for a profit, it’s time to find ways to lower your COGS or completely re-evaluate your strategy.
How to calculate the cost of goods sold
It’s time to learn how to calculate it for yourself. Follow these steps to determine the COGS of your products. Accounting software can help you with just that. It can help you track, analyze, and report for every area of your business.
1. Calculate all costs related to production
There are direct and indirect costs.
- Direct costs are the materials, parts, labor, and other elements that go into making your company’s product.
- Indirect costs are the equipment, facilities, rent, and other expenses necessary to manufacture and ship your product. This also includes your labor costs associated with shipping.
For example, if you make photo frames, your direct costs include what you pay for materials, such as metal or paper to insert stock photos into the frames. The direct labor costs would be for the people who operate the machines to make the frames.
Indirect costs would include labor costs for people who are not directly involved in producing the photo frames but are still needed, such as shipping staff.
2. Determine the starting inventory
Your starting stock is the amount of finished goods, raw materials, and work in process that you have at the start of an accounting period. On your balance sheet, this number must be the same as your ending inventory for the previous accounting period.
3. Calculate new purchases
Many companies add more products or purchase equipment to increase inventory throughout the year. The total cost of each product you add to your inventory may include additional labor expenses. For example, if you spend $ 500 on additional materials and $ 100 on labor costs, your new purchase charge will be $ 600. If you buy products in bulk, the amount you pay for them is the new purchase cost.
You can calculate your final stock by counting all your physical products or by estimating as closely as possible. By doing this, you can subtract any inventory that you were unable to sell due to defects, damage, or theft. If you have any products or materials that have been destroyed, you may need to prove that this has happened. If you have outdated inventory, you may need to prove that it has lost value.
5. Add your data to the COGS formula
You can get the final cost of goods sold using the following formula:
Starting inventory + new purchases – ending inventory = cost of goods sold
For example, you had a starting inventory of $ 100,000 and purchased $ 50,000 of additional materials and products during the year. That leaves you with a total of $ 150,000 in inventory. After you finish your tally at the end of the year, you determine that you have $ 15,000 left in products. If you enter this information in the formula, it would be:
$ 100,000 + $ 50,000 – $ 15,000 = $ 135,000
Since COGS is an expense, you then need to subtract that amount from income on the income statement.
Strategies for Managing Changes in Inventory Costs
Often, companies find that their COGS is highly dependent on other industries. For example, let’s say you own a business that makes woolen socks and you source your wool from New Zealand. If the price of oil increases dramatically, it could become much more expensive to pay shipping to get the wool for your socks. This would dramatically increase your COGS.
Let’s say you have two sets of socks, one from before the oil price spike and one after. The first set contains 200 pairs of socks at $ 5 each. The second lot contains 300 pairs for $ 10 each. The pre-price surge lot had a COGS of $ 1,000 and the post-surge lot had a COGS of $ 3,000.
Let’s say you sold 400 pairs of your total inventory of 500 pairs of socks. You can use three different methods to calculate COGS:
- Average cost method: Using this approach, you can simply add the total cost of goods sold, which is $ 4,000, and divide it by the total number of socks, 500. This would bring the average cost of a pair of socks to $ 8. This means that if you sold 400 pairs of socks, you would have a COGS of $ 3,200.
- FIFO method: FIFO stands for first in, first out. Using this strategy, you would sell the first 200 pairs for $ 5 each, then the next 200 for $ 10 each. This would give you a COGS of $ 3,000. The advantage of using this strategy, especially if market prices drive up costs, is that it keeps your COGS low and your profits higher.
- LIFO method: It means last in, first out. This means that the last pair of socks you received is the first you sell. The problem with this type of inventory approach is that a significant portion of your inventory can be very old. The reason some companies are using it, however, is because of the rising prices. If you are using LIFO, the cost of new inventory will always be higher. By calculating the most expensive inventory in the COGS, the business can reduce the levels of profitability reported for tax purposes.
Cost of Goods Sold Control Strategies
Because COGS is crucial to maintaining profitability, it is important to take steps to optimize it. Here are some strategies you might consider:
- Negotiate agreements with suppliers: Suppliers are sometimes willing to work with you on the price of goods, especially if you are willing to buy in bulk or sign a long-term contract. Look for ways to establish a long-term partnership with suppliers to reduce the cost of materials and parts.
- Organize COGS by category: Try to develop a system to classify and organize the COGS for specific products or product categories. While it takes a bit more manpower, it will give you a clear picture of the impact of specific products on your business’s revenue.
- Think about automation: Consider investing in machines that allow you to reduce the cost of labor or increase the number of products you manufacture without hiring additional people.
While it is essential to use strategies to manage COGS, the better your bookkeeping and records, the easier it will be for you to manage your inventory and calculate COGS. Accounting software can help you with just that. It can help you track, analyze, and report for every area of your business. In addition, the management of a business current account can help you track expenses like inventory, vendors, and payroll.