What Is Cost of Goods Sold and How Do You Calculate It?

What Is Cost of Goods Sold?

Cost of goods sold generally includes your variable expenses, such as raw materials or direct labor, and excludes the costs that are general to your company—the overhead and SG&A expenses—such as marketing efforts. However, some businesses may include fixed costs, such as warehouse or storage expenses. The cost of goods sold is listed as an expense line on your income statement because it’s a cost of doing business.

Calculating your cost of goods sold informs your pricing analysts of your breakeven point and pricing strategies.

When you subtract your cost of goods sold from your total sales, you get your gross profit.

When you subtract your cost of goods sold and all other expenses from your total sales, you get your net income.

How To Calculate Cost of Goods Sold

Here’s how you calculate your cost of goods sold:

Beginning Inventory + Purchases - Ending Inventory = Cost of Goods Sold

Don’t include the direct costs attributed to products/services that weren’t sold.

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Cost of Goods Sold Examples

Here’s an example using the formula:

Beginning Inventory: $30,000
Purchases: $40,000
Goods Available for Sale: $70,000
(Less) Ending Inventory: ($20,000)
Cost of Goods Sold: $50,000

Why Is a COGS Analysis Important?

• Profitability: Your cost of goods sold helps set your pricing strategies.
• Cost Management: You can analyze the drivers of your cost of goods sold for opportunities to reduce costs. This is especially important for businesses operating on lower profit margins.
• Long-Term Planning: You need to know how much sales you need to pay your expenses (at which you break even) i.e. knowing how much it costs you to make the things you sell helps you establish a sustainable, profitable operating model for your company.

Accounting Methods and COGS

These are four accounting methods to record the inventory you sold in a period:

FIFO

First in first out (FIFO) means the products manufactured earliest are sold first. Since prices generally increase, with this method, as your lowest priced items sell, your cost of goods sold becomes lower (than the LIFO) and your net income usually increases over time.

LIFO

Last in first out (FIFO) means the products manufactured latest are sold first. With this method, your highest priced items are sold, so your cost of goods sold is higher (than the FIFO) and your net income usually decreases over time.

Average Cost Method

The average cost method takes the average price of all of your manufactured products to calculate the value of your cost of goods sold.

Special Identification Method

The special identification method takes the price of every individual unit you sold. In this method, your business knows exactly which units and their price. This method works best with expensive specialty products, such as real estate, vehicles and furniture.

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What To Exclude From COGS Analysis?

Calculating your cost of goods sold and including it in your income statement isn’t required by the generally accepted accounting principles (GAAP). Businesses that sell services and no products usually don’t include a cost of goods sold—they calculate a cost of sales or a cost of services.

Cost of Revenue vs. COGS

The cost of revenue includes your cost of goods sold, along with any other expenses incurred in a sale, such as marketing efforts. Some businesses prefer using cost of revenue because it’s more comprehensive than using cost of goods sold.

Operating Expenses vs. COGS

Your operating expenses aren’t included in your cost of goods sold. They’re not directly associated with the production of your sales.

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What Are the Limitations of COGS?

It’s easy for you to incorrectly value your cost of goods sold by overstating or understating your expenses, discounts and obsolete products. When you don’t accurately calculate your cost of goods sold, you risk operating on a business model that’s unprofitable and unsustainable.

Are Salaries Included in COGS?

They are usually not. However, you can include salaries in your cost of goods sold when the labor is directly associated with the production of the sales. For instance, when you hire contractors, you may decide to include a portion of their wage into your cost of goods sold.

You Can Use COGS To Improve Profitability

Your cost of goods sold informs you of the total sales required for you to break even. This helps you set your pricing strategy to build a sustainable, profitable operating model.

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