Cost of goods sold (COGS) is another financial metric that can be difficult to wrap your head around. But there’s no need to get swamped by all the figures and financial jargon.
It may be a pain at first but stick at it. When everything clicks into place, your business becomes much smarter by all accounts.
In short, the cost of goods sold is how much it costs your business to sell inventory over a given period of time. This could be monthly, quarterly, or yearly. You could calculate COGS every month, and also do a quarterly review to make sure everything lines up. Other businesses may only do this quarterly.
It’s up to each business owner to figure out what is best for their needs. In any case, the basic principles stay the same.
COGS is a method of giving a real-world valuation to your inventory. It’s a must-know for proper inventory management. Your material and labor expenses could fluctuate from month to month. It pays to keep up with the price of getting your goods to market.
What are the costs Included in COGS?
The following costs are often included in COGS:
- Product cost – how much it costs to order items from your manufacturer or distributor
- Freight in – how much it costs to get those purchased products delivered to you
- Duties and fees – any costs associated with design, kitting, or assembly of the products
The following are things not included in COGS:
- Rent – for example, the monthly cost of your warehouse or storage facilities
- Online advertising – digital ads through Facebook, Instagram, or YouTube
- Payment processing fees – Stripe or PayPal per-transaction costs
- Product R&D – the design and development required to bring the product to its finished state
- Freight out – delivery to the customers
- Marketplace fees – charges from platforms like eBay, Etsy, or Amazon
- Employee salaries – this includes contractors like designers or market researchers
- Owners must account for these expenses, of course. They simply record them in a separate line item — usually operating expenses (OPEX) — for more accurate analysis.
How to Calculate COGS?
Before you get started, you need to have the following details with you:
- On-hand inventory numbers for all your SKUs
- Costs of ordering items from your manufacturer or distributor
- Revenue from products sold
Once you have the details, calculating COGS is a relatively simple one:
Value of starting inventory + inventory purchases made during the reporting period – value of ending inventory = Cost of goods sold
This means if you start with $2,400 on-hand inventory when the quarter begins, purchase $5,000 of inventory during the quarter, and end up with a final inventory value of $4,000, your COGS for the quarter would be $3,400 (2,400 + 5,000 – 4,000).
But how do we arrive at these numbers? That all depends on how you decide you value your inventory.
Choosing a Costing Method for COGS: FIFO, LIFO, or Average Cost
First In, First Out (FIFO)
Many large manufacturers regard this as the “theoretically correct” inventory valuation method. It asserts that the first materials and stock to come into inventory, will be the first out when sold.
Advantage: This gives you a more accurate valuation of your current inventory. This is because all present inventory best represents the cost of the inventory most recently purchased.
Disadvantage: The COGS reflects older historical costs. That means the gross profit calculation may not reflect the actual figure.
Last In, First Out (LIFO)
This is selling the most recent additions to your inventory first. If the cost of raw materials increases, the company will sell the higher-cost goods first. This means a business can report higher deductions for tax purposes.
Advantage: It can be good for a company’s cash flow as it records less taxable income.
Disadvantage: The last items added to inventory are usually the most expensive. This can inflate your COGS.
Measured Average Cost (MAC)
As the name suggests, this method takes your average unit cost and applies it to all goods sold in that period. To calculate it, simply multiply the average purchase price by the number of units sold.
Advantage: It gives a more realistic reflection of your COGS. Using averages mitigates for changes in market prices and other changeable factors.
Disadvantage: The IRS and other tax authorities may still require you to report your inventory costs using another method (e.g. LIFO).
Each of the above accounting methods are accepted under GAAP.
The conclusion — using MAC is the best of both worlds. This has been the most common practice for businesses as it is the easiest and most useful method for their needs.
Averaging out costs gives you the whole picture. It does not allow COGS to change significantly due to market fluctuations.
This method has stuck around for a reason – it works.
Calculating Cost of Goods Sold: Analysis with an Example
Say you have a handmade jewelry business. You start with $1000 of inventory. This includes $800 in raw materials and $200 in direct labor (manufacturing) costs.
You sell $600 worth of jewelry (leaving $400 remaining in stock).
To keep up with this demand, you manufacture $500 more jewelry, including $100 in labor costs.
You then sell $350 worth of jewelry more.
Over this period, the cost of goods sold formula will look like this:
COGS (Monthly) = (1000 + 500) – (550) = $950
Now you know the cost of goods sold, you can decide if you have a reasonable markup for your products. For handmade jewelry, this could be at least two times the material and labor cost. So, if the cost-price $1,500 was sold with a x2 markup, then the revenue would be $3,000.
You can then use this to calculate gross profit:
Gross Profit = 3,000 – 950 = $2,050
Of course, it’s possible to calculate the cost of goods sold without including direct labor costs.
Doing this, you can work out the ratio of labor to manufactured goods on a larger scale. This is useful to consider when analyzing your workshop’s overall efficiency.
Using COGS to Calculate Gross and Net Profit
Phew! We made it to the other side of all those equations. For those of you who don’t have a background in accounting, that probably felt like drinking from a firehouse.
If you do not fully understand each calculation method, go back and read very slowly. Even better, try to plug in some of your own numbers so the concepts really sink in.
Once you have COGS, you can unlock a whole host of other insightful metrics such as gross and net profit.
Simply plug your data into these formulas:
Gross profit = Gross Revenue – COGS
Net profit = Gross Revenue – COGS – Expenses
From there, you can quickly discern whether or not you’re in the red or in the black, and brainstorm necessary tweaks to grow your profitability.
Use Bloom Analytics to Track & Calculate Your COGS