If you want to run a successful business, you need to know how to calculate cost of goods sold, commonly referred to as COGS or the cost of sales. These expenses arise during the manufacturing phase of a product. The term is usually on a company’s income statement. It is an essential metric to calculate, as it directly impacts the profitability and helps determine the pricing strategy. A successful pricing strategy allows a company to grow while competitors struggle to break even.
Some of these costs are:
- Raw materials
- Storage fees
- Factory overheads
These are direct costs because they are directly associated with the product’s manufacturing. Another type of cost that is not part of the process is indirect cost. Some of these expenses include:
Knowing which costs to include in the COGS calculation is crucial to help determine the exact amount. Adding indirect costs or other unrequired expenditures overcomplicates the whole process. This guide will explain step-by-step how to calculate cost of goods sold.
4 Reasons Why Businesses Calculate Cost of Sales?
Understanding the costs of goods sold is vital to a business. It is a critical piece of information in the business’s accounting period statement. Without this, organizations may have a challenging time controlling their expenses and boosting their profit margins.
There are four core reasons why businesses calculate cost of goods sold. These are setting prices, reducing costs, lowering taxes, and calculating the net income.
1. Establishing product prices
This is the primary reason for knowing your company’s COGS. If you know how much it costs you to make a product, you can identify your “break-even” point. From there, you can then determine what price would give you a healthy profit margin.
2. Reduce operating expenses
Upon calculating COGS, businesses can identify operating expenses, make informed decisions, and update business strategies. Businesses can implement various strategic cost reduction tactics to lessen their overall expenditure. One example is cutting back on bills by finding new suppliers selling quality materials at a lower price.
3. Minimal tax rate
With an accurate calculation of costs, businesses can also ensure they are paying the minimum tax rate required by law. If the COGS on the balance sheet have an incorrect calculation, the business may be under or overtaxed. This can cause issues down the line with the internal revenue service.
4. Calculating the gross profit and net income
COGS is a fundamental component in determining profit and net income. Businesses can make financial statements and forecast future earnings by analyzing gross profit and net income.
Calculating the costs of sales is a must for every business and the restaurant industry is no exception. The importance of average restaurant profit margins is a primary focus of restaurant owners. It is because it helps them keep track of their business performance.
4 Steps in Calculating Cost of Goods Sold
Now that you understand the importance of COGS, let’s learn how to calculate it in four simple steps. We’ve broken down the process so you understand all the numbers and information you need to collect to get this number. Once you master this process, keeping your books balanced will help you manage the cash flow.
The first step in calculating cost of goods sold is determining the related production costs. Since multiple expenses are in the company’s accounting statement, it is best to divide them into two parts. Grab a piece of paper or open up a spreadsheet on your computer.
In the first column, note the direct costs, which include materials, labor, manufacturing overhead, and other expenses. Write the indirect costs in the second column, such as rent, utilities, and insurance. These are necessary for the business to operate but do not have a direct impact on production.
Creating a separate list ensures that you’re only using production-related costs for COGS and excluding business expenditures. It will help in determining the actual cost of sales.
After identifying these costs, businesses can calculate the total cost of goods sold for a given financial period.
Calculating Cost of Goods Sold Step 2: Determine the Beginning Inventory
After identifying the direct costs, you must then determine the beginning inventory for the accounting period. It includes the value of products or materials at the start of the period. Hence, the name, beginning inventory.
Calculating Cost of Goods Sold Step 3: Add Purchases
After determining the beginning inventory, the third step is to add all new purchases made during the accounting period. This may include extra labor costs, raw material costs, or any other expense related to the product. This step is crucial and must not be left out. The direct cost column created in the first step can help simplify this process. Using that, you can write every subsequent purchase in that column to avoid confusion about missing expenditures.
Calculating Cost of Goods Sold Step 4: Determine the Ending Inventory
After adding all the new purchases, it’s time to determine the ending inventory. This refers to the value of all unsold products at the end of the covered period. However, not all goods remaining in stock qualify as ending inventory.
Why? Because ending inventory should only be the sum of all remaining marketable products. Any damaged, defective, or lost products don’t go towards this amount.
How to Calculate Cost of Goods Sold?
After determining the direct costs, starting and ending inventory, and noting additional purchases, calculate the cost of goods sold. If you are wondering how to calculate cost of goods sold, there are two ways to accomplish it. It is possible using a formula or with the help of a calculator.
Cost of Goods Sold Formula
Calculating the cost of goods sold formula is straightforward:
Beginning inventory + purchases during the period - ending inventory = COGS
This calculation gives the total cost of the goods sold during the period. It is a necessary figure for businesses to know, as it helps determine their gross profit margin. To better understand this formula in action, here is an example.
Suppose a business had $10,000 worth of inventory at the beginning of the year. During the year, they made additional purchases totaling $50,000 and ended the year with $15,000 worth of inventory. Using the formula, their COGS would be $45,000.
Beginning inventory: $10,000
Additional purchases: $50,000
Ending inventory: $15,000
$10,000 + $50,000 - $15,000 = 45,0000
You may have noticed that direct costs are not part of this formula. Direct costs are part of the additional purchases. That is why all follow-up expenses are in the direct cost column. Please check step three, “Calculating Cost of Goods Sold Step 3: Add Purchases”, for a clear picture.
Cost of Goods Sold Calculator
A cost of goods sold calculator is a useful tool for businesses to accurately calculate their cost of goods sold. With an online financial calculator you can input the necessary information for calculating costs of goods sold. Then, this handy tool takes care of the rest.
Similar to the formula above but without the manual calculation, enter the beginning inventory, purchases and the ending inventory into the relevant fields. The calculator also gives the option to select some popular currency from the list. This is helpful for those, who don’t want the expense showing up in US dollars. After filling in the necessary information, click on the calculate button and it will reveal the costs of sales in the COGS field.
The cost of goods sold calculator helps businesses get an idea of their expenses. With this, they can make decisions about pricing and profitability. It is vital to regularly review and update the cost of goods sold calculation to ensure accurate financial reporting.
How to Calculate Cost of Goods Sold Without Ending Inventory
Sometimes a business’s closing inventory may turn out to be zero. It means that there is nothing left in stock. In this case, the cost of goods sold formula would require a minor adjustment.
If you don’t know how to calculate cost of goods sold without ending inventory, here is what you need to do.
From this formula
COGS = Beginning Inventory + Additional Purchases - Ending Inventory
Simply omit the ending inventory. So, the new formula will be:
COGS = Beginning Inventory + Additional Purchases
By summing up the beginning inventory and additional purchases, you can calculate the COGS for that period of time.
3 Accounting Methods to Calculate Cost of Goods Sold
There are different accounting methods businesses employ to calculate cost of goods sold. Each method has its advantages and disadvantages. Businesses should choose the approach that best suits their needs and objectives.
Before moving further it is important to clarify that the account methods and the COGS formula are two separate concepts. For example, the COGS formula is a general framework. The calculation determines the cost of goods sold for an account period. The period depends on the business; it could be a month, a year, etc.
On the other hand, the accounting methods provide an alternative way to determine and assign the value based on different assumptions and considerations. With this, businesses choose how to allocate the cost of goods sold in a company’s financial statement.
There are several accounting methods, but the three most popular ones are:
Which accounting method a business chooses to calculate cost of goods sold is entirely up to each company. However, it will depend on factors such as the type of products, tax regulations, management preferences, etc. It is crucial to adopt one method and stick with it to ensure accurate financial statements.
How to Calculate Cost of Goods Sold Using Fifo?
Understanding what Fifo is and how to calculate it is simple. Fifo stands for “first in, first out”. This means the first items purchased or produced in your inventory are the first ones to leave when you make a sale. This method is useful for businesses that deal with perishable goods or those that experience frequent price fluctuations. In this way, they sell their expensive products first.
Here are some rules to keep in mind when using Fifo:
The oldest items in the inventory are the first to leave.
The newest items not sold go into the ending inventory.
If prices rise, the cost of goods sold will fall, and income will increase.
Here are some reasons why a company may prefer to use Fifo.
It is easier to understand and implement by following the flow of the inventory.
There are less chances to make mistakes with this method.
A company can calculate how much each item costs them.
During inflation since the first items are sold, this results in lower COGS, which means higher profits. Unfortunately, this also means a higher tax.
Here is an example of how to calculate cost of goods sold using Fifo.
Company A has 100 items which cost $10 each. After a while, they made additional purchases and that item now cost $20 each. There is a difference in cost of items for each batch and the company wants to calculate their COGS. So, they use the Fifo method.
Opening inventory: 100 units for $10 each.
Additional purchases: 50 units for $20 each.
Total inventory: 150 units at the end of the accounting period.
Units sold: 120 units.
So, the cost of goods sold will be the sum of each of these equations added together:
100 x $10 = $1000
20 x $20 = $400
$1000 + $400 = $1400.
How to Calculate Cost of Goods Sold Using Lifo?
Lifo stands for “last in, first out” and assumes that the most recently purchased inventory is the first to go. To calculate COGS using Lifo, you would use the cost of the most recent purchases.
During inflation, a company may prefer to use the Lifo accounting method because it results in higher inventory cost. A high COGS means less profit which results in a lower tax rate.
Here is an example of how to calculate cost of goods sold using Lifo.
Opening inventory: 100 units for $10 each.
Additional purchases: 200 units for $20 each.
Closing inventory: 50 units.
Units sold: 150
First we need to calculate the total costs of goods available for sale.
100 x $10 = $1000
200 x $20 = $4000
Total COGS = $1000 + $4000 = $5000
Now we need to calculate, the last 50 units in the closing inventory are at a cost of $20.
50 x $20 = $1000
So the total cost under the Lifo method is:
$5000 - $1000 = $4000
One thing to note is that Fifo and Lifo are merely assumptions. It doesn’t actually track the physical presence of the inventory. A company uses Fifo and Lifo to calculate their costs which determines their profits. The profits declared in the balance sheet will affect their income tax.
How to Calculate Cost of Goods Sold Using the Average Cost?
To calculate the average cost, there are two steps:
Divide the total cost of all units by the total number of units to get the average cost per unit.
Then, multiply this average cost per unit by the number of units sold during the time period.
Here is an example of how to calculate cost of goods sold using the average cost.
Opening inventory: 100 items for $50 each
Additional purchases: 200 items for $60 each
Closing inventory: 150 items
- First, calculate the average cost per unit. The formula is:
(Opening Inventory Cost + Additional Purchases) / (Opening Inventory Quantity + Purchases Quantity)
Opening inventory cost: 100 x $50 = $5000
Additional purchases: 200 x $60 = $12000
($5000 + $12000) / (100 + 200) = $17000 / 300 = $56.67 (the average cost per unit).
- Second, multiply the average cost per unit by the quantity sold during the accounting period. The formula is:
Average Cost per Unit: $56.67
Quantity Sold: 150 items
$56.67 x 150 = $8500.5
Therefore, the COGS using the Average Cost method is $8500.5.
How To Reduce the Cost of Goods Sold?
Businesses are always looking into new ways for COGS reduction. This is because decreasing costs will increase their profit margins. However, merely slashing various expenses is not the ideal way to increase revenue. It is important to understand your purchases and suppliers and discover ways to reduce costs without compromising the quality of your products.
Here are eight ways in which businesses can reduce the cost of goods sold:
- Finding the optimal location for distribution centers using the center of gravity method.
- Buying items in bulk from suppliers may lead to discounts.
- Searching for alternate suppliers that provide the same raw materials at a reasonable price.
- Negotiating better deals with suppliers by leveraging long-term contracts or committing to larger orders.
- Utilizing technology to streamline operations and reduce labor costs.
- Conducting regular inventory checks to avoid overstocking or understocking.
- Outsourcing specific tasks to countries with lower labor costs.
- Implementing sustainable practices can lead to cost savings in the long run by reducing waste and energy consumption.
These eight methods are merely suggestions. Different businesses can apply various COGS reduction methods. They need to analyze their specific operations before committing to any strategy.
Using formulas, accounting methods, and various cost reduction strategies, businesses can calculate the cost of goods sold. To ensure it remains low, businesses must regularly check the implemented tactics for different periods.
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