How to Calculate Cost of Goods Sold (COGS): A Complete Guide

Understanding your costs is essential for sustaining profitability in manufacturing.

Many manufacturers face the challenge of accurately determining the total cost of raw materials, labor, and production. Without a clear grasp of these costs, businesses risk underpricing their products or overspending on materials, ultimately jeopardizing their financial health.

The solution lies in calculating your Cost of Goods Sold (COGS). With the right accounting software, you can streamline this process, ensuring accuracy and efficiency in tracking your production costs.

To begin, determine your 'beginning Inventory', which is the value of your inventory at the start of the accounting period. Next, add the total cost of raw materials and goods purchased throughout the period, known as 'purchases during the period'. Finally, subtract the unsold inventory value at the end of the period, referred to as 'ending Inventory.'

By accurately tracking these elements, big or small business owners can determine the total cost associated with producing goods sold during the period. 

Importance of COGS in accounting 

Calculating COGS is vital for businesses operating in competitive markets. It is deducted from a company’s revenues to determine gross profit, a fundamental measure of profitability. Without an accurate calculation of COGS, it becomes impossible to assess your company's true net/gross profit margin.

A comprehensive understanding of COGS enables analysts, investors, and managers to estimate a company’s net income effectively. Since an increase in COGS directly leads to a decrease in net income, analyzing COGS can help identify inefficiencies in the production process. This analysis often uncovers opportunities for improvement, such as sourcing less expensive raw materials, measuring inventory turnover, and minimizing inventory holding costs.

Additionally, COGS is categorized as a business expense on the income statement, which makes it crucial for income tax purposes. Companies can frequently deduct the costs incurred in producing goods or services; however, this deduction may not apply universally:

• Capital-intensive businesses: Companies in sectors such as manufacturing and mining are more likely to take advantage of these deductions.
• Service-based companies: Businesses like medical and legal practices typically do not list COGS unless they are selling physical products.

Finally, a clear understanding of COGS helps companies prepare for scrutiny from the Internal Revenue Service (IRS) and its auditors, who examine everything from purchase orders to employee records for potential discrepancies.

How to calculate COGS

We now have a understanding of the formula for calculating the Cost of Goods Sold (COGS). To further clarify this concept, let’s take a practical example:

Imagine Company A recorded $3.5 million worth of inventory at the beginning of the 2024 fiscal year. Over the course of the year, Company A invested an additional $4.2 million in inventory costs, which included essential raw materials and supplies. By the end of the 2024 fiscal year, Company A had $2 million worth of inventory remaining that had not yet been sold.

In this scenario:

• Beginning Inventory: $3.5 million
• Purchases During the Period: $4.2 million
• Ending Inventory: $2 million

Now, we can use the Cost of Goods Sold formula:

COGS = Beginning Inventory + Purchases During the Period - Ending Inventory

Substituting the values into the formula, we get:

COGS = ($3.5 million + $4.2 million) − $2 million = $5.7 million

This calculation shows that Company A incurred $5.7 million in costs directly associated with the goods sold during the fiscal year. 

Inventory valuation methods for COGS

The term "inventory" can encompass a wide range of items, including raw materials, work-in-progress goods, and finished products. Since COGS has tax implications and affects the company's profitability, it’s crucial to clearly define what counts as inventory before performing this calculation.

This means considering not just the physical items on hand but also any associated costs, such as shipping, handling, and storage fees. 

The value of the COGS in accounting can vary based on the inventory valuation method a company chooses. Here are the four main methods used to record the inventory sold during a period:

• FIFO (First In, First Out) Method: This method dictates that the first items purchased or produced are the first to be sold. Since prices usually rise over time, a company using FIFO sells its cheaper products first, resulting in lower COGS and, consequently, higher net income.
• LIFO (Last In, First Out) Method: Under LIFO, the most recently acquired goods are sold first. During periods of rising prices, this leads to higher-cost items being sold first, resulting in a higher COGS and lower net income over time.
• Average Cost Method: This method calculates COGS based on the average cost of all goods available for sale, regardless of when they were purchased. It smooths out price fluctuations, preventing COGS from being significantly impacted by the costs of any single purchase.
• Special Identification Method: This method involves tracking the specific cost of each individual item sold. It's commonly used for unique or high-value items, such as cars, real estate, or rare jewelry, allowing businesses to know exactly which item was sold and at what cost.

Making profits or just making excuses? 

While your accounting software is a fantastic tool for keeping track of inventory and calculating COGS, don’t forget to chat with a Certified Public Accountant (CPA) or a tax professional. They can help you uncover all those sneaky costs involved in developing your product line or service that you might miss on your own.

In the meantime, try your hand at a basic calculation using the COGS formula. This quick exercise will reveal key insights into where your money is going and might even reveal some areas where you can save a few bucks.

So, team up with your software and a financial expert, and you’ll be well on your way to making smarter business decisions while keeping your finances in tip-top shape!

Manage your finances without breaking the bank. Check out the top free accounting software options available! 

This article was originally published in 2018. It has been updated with new information