How Do I Calculate Cost of Goods Sold (COGS)?

Have you ever stared at your financial statements and wondered why money seemed to be slipping through your fingers? 

Every successful business owner knows that profits don’t just appear out of thin air, they stem from a deep understanding of costs and revenues. 

Among the most critical figures in your financial arsenal is the Cost of Goods Sold (COGS). But what exactly is COGS, and why should you care? 

With doola Bookkeeping at your disposal, you can rest assured that your COGS will always be accurate and up-to-date. It tracks all your inventory purchases, sales records, product returns, discounts, and other related costs to calculate your COGS automatically.

You’re probably asking, “How do I calculate Cost of Goods Sold (COGS)?” We’ll tell you how, what it really means, and why knowing this number can empower you to make smarter business decisions. 

So, if you are ready to take control of your finances, let’s dive right in!

What Is Cost of Goods Sold?

In simpler terms, COGS is the cost of goods sold during a specific period, which refers to the direct costs incurred in producing and acquiring goods that a company sells. 

COGS allows businesses to determine their overall profitability and make informed decisions regarding pricing strategies, inventory management, and operational efficiency. This includes raw materials, direct labor costs, and overhead costs directly connected to your profit-making activities, such as utilities for a manufacturing facility.

These 3 components are directly involved in determining the COGS:

1. Direct Materials

These are the raw materials used in manufacturing a product. This includes everything from wood and metal for furniture manufacturers to fabric and thread for clothing companies.

2. Direct Labor

This involves the cost of labor required to produce goods directly related to sales. For example, it would include wages paid to factory workers who assemble products or package products for sale.

3. Overhead Expenses

These are the indirect costs associated with production but not directly tied to specific units or batches of products. Examples include rent, utilities, insurance, and maintenance expenses.

However, only direct expenses should be included in COGS calculations as these are directly attributable to the production or acquisition of goods being sold.

Note:

COGS can be calculated only on products you actually sold and not include inventory you still have on hand.

Since it’s all about the production costs you incurred, you cannot include expenses for the general operation of your business.

Cost of Goods Sold (COGS) Formula

Before calculating your COGS, you need to know the value of your inventory by adding up all the costs associated with getting your product ready to sell to your customer.

The costs you can and can’t include vary by industry and product. While you can check the IRS article about COGS, we recommend professional bookkeeping to ensure you’re not missing anything. 

When you have the total cost of your inventory, you just need to know how much you actually sold to calculate your COGS using a simple formula: 

COGS = Beginning Inventory + Inventory Purchases – Ending Inventory

The beginning inventory refers to the inventory value that you had at the beginning of an accounting period or year, and purchases refer to any new inventory acquired during an accounting period or year.

Ending inventory is the value of inventory remaining at the end of an accounting period or year after deducting what has been sold during that time. It includes both finished products ready for sale and incomplete products still in production.

Step-by-Step Guide to Calculating COGS

While calculating COGS may seem like a daunting task, it can be broken down into a simple step-by-step guide, breaking down each component of COGS to help you better understand the process.

Step 1: Determine Beginning Inventory

The beginning inventory represents the total cost of goods that are on hand at the start of a particular time frame, such as a year or quarter. 

It includes all finished goods ready for sale and any raw materials or work-in-progress inventory. For example, at the beginning of 2024, Company XYZ had $50,000 worth of inventory.

Step 2: Add Purchases or Production Costs

Next, you need to add any additional purchases made during the specified period. This includes both direct and indirect costs associated with producing or acquiring goods. 

Direct costs may include materials used in production, while indirect costs may include labor and manufacturing overhead expenses.

Let’s assume the same Company, XYZ, has purchased $100,000 worth of raw materials throughout 2024.

Step 3: Subtract Ending Inventory 

After determining the beginning inventory and adding purchases/production costs, you can subtract the ending inventory from this total amount. 

Ending inventory represents all unsold goods left over at the end of a specific period. Continuing with our example, if Company XYZ has $70,000 worth of ending inventory at the end 2024.

Step 4: Calculate COGS

The final step is to calculate the cost of goods sold by using the following formula:

COGS = Beginning Inventory + Purchases – Ending Inventory

Beginning Inventory ($50,000) + Purchases ($100,000) – Ending Inventory ($70,000) = $80,000

So, in our example, Company XYZ’s COGS would be $80,000.

Note:

COGS may vary depending on the accounting method used, such as the first-in-first-out (FIFO) method or the last-in-first-out (LIFO) method.

Book a demo with us if you have any questions or need assistance with calculating your business’s COGS.

Accounting Methods for COGS Calculation

There are 3 main accounting methods for calculating COGS. Each method has advantages and disadvantages, and companies can choose which one to use based on their specific needs and circumstances.

1. FIFO Method

FIFO stands for “first-in, first-out,” and it assumes that the first units of inventory bought or produced are also the first ones to be sold. 

Under this method, the cost of goods sold will be calculated using the oldest or earliest costs in inventory when calculating COGS. 

This means that the remaining inventory will be valued at the latest or most recent costs, making it easier to track their actual cash flows since older inventories tend to have lower prices due to inflation.

2. LIFO Method

Unlike FIFO, LIFO uses more recent costs and operates under the assumption that the last units of inventory bought or produced are also the first ones to be sold.

One notable benefit of using LIFO is that it better matches current market prices, as more recent inventories usually have higher prices due to inflation. This can result in lower taxable income, making it an attractive option for tax purposes.

3. Weighted Average Cost Method

The Weighted Average Cost method calculates COGS by taking the average cost of all units in inventory and applying it to the number of units sold. 

This method comes in handy when a company does not want to track individual costs for each item in inventory and instead wants a more general overview.

Since this method averages out costs, it provides a smoother balance sheet as there are fewer fluctuations in inventory values compared to FIFO or LIFO methods.

Common Mistakes When Calculating COGS

There are some common challenges that many businesses face when calculating their COGS, leading to inaccurate results and potential financial losses. 

Let’s delve into 2 major mistakes to avoid when determining your COGS, including non-COGS expenses and ignoring shipping and fulfillment costs in ecommerce.

❌ Including Non-COGS Expenses

Non-COGS expenses are not directly related to the production or acquisition of goods but rather represent overhead costs such as administrative expenses, marketing costs, or rent.

Including these non-COGS expenses can inflate your COGS figure and give you an inaccurate understanding of your product’s profitability. 

However, avoiding this mistake is easy since you only need to track all expenses related to the production or acquisition of goods separately from other overhead expenses. 

By separating these costs, you can accurately calculate your COGS without overestimating its value with additional non-COGS expenses.

❌ Ignoring Shipping & Fulfillment Costs in Ecommerce

One common mistake most ecommerce businesses make is ignoring shipping and fulfillment costs, causing discrepancies in the actual cost of your products. 

These expenses include everything from packaging materials, labor costs for preparing orders, and shipping fees.

By ignoring these costs, you may overestimate your profit margins or underpricing your products. 

Ready to Master COGS Calculation? doola Bookkeeping Can Help!

One tool that can greatly assist in COGS calculation is doola Bookkeeping, a user-friendly software with automated revenue and expense tracking.

It also allows you to categorize expenses related to your product or service offerings. From raw materials to labor costs, you can allocate each expense under the correct category. 

Furthermore, doola’s sales tracking feature makes it easy for business owners to keep an eye on their revenue streams while simultaneously monitoring their associated costs. 

With this information readily available at your fingertips, you can effortlessly track your COGS for a clear understanding of how much profit you have generated.

Aside from our all-in-one bookkeeping software with flexible pricing, another great resource that comes in handy when mastering COGS calculation is our dedicated bookkeeping services. 

With their expertise, they can handle all aspects of COGS calculation, leaving you with more time to focus on other aspects of your business.

Book a demo with us today to improve your company’s financial health and performance.

FAQs

What expenses are included in COGS?

COGS includes all direct costs like the price paid for products, materials, and supplies directly used in production or resale, labor costs directly involved in production or resale, and shipping and handling fees.

How do I calculate COGS for a service-based business?

Calculating COGS for a service-based business can be more complex as no tangible products are being bought or resold. 

Instead of physical inventory costs, you will need to consider factors such as labor hours spent providing services and any direct expenses incurred related to those services.

You can also allocate indirect overhead costs, such as rent or advertising, based on the percentage of time they were dedicated to providing services.

Is COGS the same as operating expenses?

While both play an essential role in determining profitability, they represent different aspects of your business’s financials. 

Operating expenses refer to the costs associated with running your business, such as marketing and advertising expenses, administrative costs, and rent. 

COGS are solely focused on the cost of producing or acquiring goods sold during a specific period.

How does inventory valuation affect COGS?

Inventory valuation refers to how you determine the value of your inventory at any given point in time. 

This can impact your COGS because it determines the value of the products or materials used in calculating the cost of goods sold. 

Can COGS be deducted from taxes?

Yes, you can deduct COGS from your taxes as they are considered expenses incurred in generating revenue for your business. 

However, it’s important to invest in professional tax filing services to ensure proper handling of all relevant expenses for tax purposes.