Your company's cost of goods sold (COGS) consists of all the direct costs associated with producing goods or services. These costs might include:
- The cost of raw materials used in manufacturing products or inventory bought for resale
- The cost of direct labor involved in manufacturing
- Freight, storage, and packaging costs
- Factory overhead
Calculating costs of goods sold helps you determine the “true cost" of the merchandise or services sold during your accounting period—whether that's a month, quarter, or year. COGS doesn't include the cost of merchandise purchased during the period that is still in inventory.
Calculating Cost of Goods Sold
The formula for calculating cost of goods sold is:
Beginning Inventory + Purchases – Ending Inventory = COGS
Beginning inventory is the value of products or raw materials you started with. Purchases are the actual costs you added to stock during the year and any direct materials, freight, storage, packing costs, and overhead incurred during the period. Ending Inventory is the value of what remains at the end of the accounting period.
COGS doesn't include any indirect costs, such as sales or marketing expenses, legal costs, insurance, etc.
To illustrate, say you own a coffee roasting company. As of January 1, 2021, your beginning inventory is $50,000. At the end of the year, you have $45,000 of inventory remaining. During the year, you spent $200,000 producing your products, which includes:
- Raw coffee beans: $100,000
- Direct labor for roasting: $75,000
- Freight, storage, and packaging costs: $10,000
- Roasting plant overhead: $15,000
Your cost of goods sold for 2021 would be:
Beginning Inventory: $50,000
Ending Inventory: -45,000
Cost of Goods Sold and Inventory Costing Methods
Your cost of goods sold can vary depending on the inventory costing method you use. There are three primary inventory costing methods:
- First in, first out (FIFO). The products you purchase first are assumed to be the ones you use or sell first.
- Last in, first out (LIFO). The most recent items produced or purchased are assumed to be the first ones sold.
- Weighted average cost. Inventory items receive the same valuation, regardless of when and at what cost each was purchased. You divide the total cost of items in inventory by the number of units available to get the weighted average cost.
Using the FIFO method will result in a lower cost of goods sold in times of rising costs because you're calculating COGS based on lower-cost inventory. Conversely, using the LIFO method will result in a higher COGS because you're using higher-cost inventory.
Your choice of inventory costing method doesn't affect the actual physical flow of products—it's just for accounting for costs on your financial statements and tax return.
Why Is Cost of Goods Sold Important?
Cost of goods sold is reported on your company's income statement, directly under sales or revenue. It's also reported on Form 1125-A, Cost of Goods Sold, of your business tax return, or Schedule C, Profit or Loss From Business, for sole proprietorships and single-member limited liability companies (LLCs).
When you subtract cost of goods sold from net sales, the result is your company's gross profit. This is the income your business earns before subtracting taxes and other operating expenses.
Gross profit is an important metric as it indicates how efficiently your business uses its labor and materials to create the products and services you sell. You also use gross profit to calculate your gross profit margin, which is a metric that measures the financial health of your business.
To calculate gross profit margin, you divide your gross profit by your net sales.
Say your coffee roasting company has net sales for 2021 of $500,000. In that case, your gross profit would be $295,000 ($500,000 - $205,000) and gross profit margin would be 0.59, or 59% ($295,000 / $500,000).
Is that a good gross profit margin? That depends on your industry. According to CFO Hub, the average gross profit margin for all companies is just above 30%, but different industries can have higher or lower average gross profit margins. For example, in an automotive business, which relies heavily on parts and labor, a gross profit margin of 10% would be healthy. On the other hand, a consultant who doesn't carry inventory and primarily “sells" their knowledge might have a gross profit margin of 99%.
It's also helpful to compare your gross profit margin over time. For example, a falling gross profit margin could signify that you need to increase prices or look for ways to cut costs.