Have you ever dreamed of starting your own business? Perhaps you want to take your miniature furniture-making hobby to the next level and open a shop, or maybe you want to transform your knitting-sweaters-for-your-dog habit into a lucrative income.
Even if your business is a little less niche than these two examples, there are tons of financial and logistical terminology you’ll have to familiarize yourself with before you begin pursuing your entrepreneurial adventure.
If you are starting your own small business, chances are you will also be responsible for keeping track of your finances. If this is the case, one extremely important concept you’ll be working with is “cost of goods sold”. While this sounds fairly straightforward, there are several steps and calculations involved in determining your cost of goods sold or “COGS” as the pros say.
Not only will calculating your COGS help you make smart choices for your company but, like all great things involved in the magical world of business, it’s required by the IRS. We’re going to cover everything you need to know about the cost of goods sold so that you’ll be able to crank out your COGS like a pro in no time.
What Is the Cost of Goods sold?
Before we whip out our calculators, we might as well start by covering the basics. The cost of goods is the total amount that it costs your company to produce goods. This includes the necessary materials as well as the cost of labor needed for production.
The keyword here however is production. This means that all indirect expenses are included when calculating the COGS, such as sales, distribution, and marketing.
For retailers, calculating the cost of goods sold is a relatively simple process. However, things can get more complicated depending on the industry and the manufacturing process of each specific product. A company’s COGS is listed on its income statement, which details the revenue the company makes.
The COGS is used to calculate the company’s gross income, meaning the amount of profit a company makes over a certain period of time. To calculate gross income, the COGS is subtracted from the company’s sales revenue, so a lower COGS typically leads to higher gross income.
How to Calculate the Cost of Goods Sold
The COGS calculation is fairly straightforward. The potential challenge is arriving at your numbers to start with. Here’s the cost of goods sold formula:
Beginning Inventory+Purchases during the period-ending inventory=cost of goods sold
Let’s take a closer look at each piece of this COGS formula, and what you need to do to make sure that you are using the correct numbers.
The first thing is to determine your beginning inventory count.
“Beginning” refers to the beginning of the year, as COGS is the cost of goods sold in fiscal each year. Once you’ve determined the size of your inventory, you’ll have to determine how much it’s all worth. The value of your beginning inventory is your inventory’s worth.
However, if we are referring to our miniature furniture-making friend, arriving at a monetary value is a little more complicated. In their case, labor costs and the cost of materials also play into determining the value of your inventory.
According to the IRS, manufacturers should arrive at their beginning inventory amount by adding the following:
- The total cost of raw materials
- work in process
- finished goods and materials
- supplies used in manufacturing the goods
- cost of labor
- “Other costs” such as shipping costs and warehouse expenses like rent and electricity
Ideally, this number should be the same as your Ending Inventory balance from the previous accounting period, so if you’ve already taken inventory, you’re in luck.
Purchases During the Period
The next step is calculating all of the purchases your business has made throughout the year in relation to your inventory. These are also known as direct costs. Your business will add to its inventory throughout the year so it’s important to keep track of the cost of all your new inventory. This includes the total manufacturing cost as well as the shipping costs for each finished product. These are known as indirect costs.
As you order new items throughout the year, it’s also important to be aware of the changing costs of materials and resources. Let’s pretend that the cost of glue increases dramatically throughout the year. This means that the same miniature chair manufactured later in the year will be worth more than one made before the price of glue surged. Additionally, the cost of all returned goods has to be subtracted from your purchase amount.
Of course, making purchases and increasing inventory requires capital. If you are a small or new business, however, acquiring that capital can be a challenge. Seek Capital specializes in helping small businesses find the financial solutions they need to grow and succeed, providing them with same-day approval.
The final step will be calculating your ending inventory. This process is virtually the same as calculating your beginning inventory. It involves tallying up what your remaining inventory is at the end of the year. For a damaged inventory, provide an estimate of its remaining value.
Furthermore, for fully damaged worthless inventory, you’ll have to prove to the IRS that the items are in fact destroyed. Similarly, for obsolete inventory that has gone down in value, you will have to provide evidence for its depreciation. Once you’ve arrived at your ending inventory value, you’ll have all the pieces you need to calculate the COGS for your business.
To further clarify things, let’s take a look at another example.
Dale Wood manufactures and successfully sells expensive products like miniature furniture. At the beginning of the year, he determines that his beginning inventory is worth $50,000 dollars, after adding the costs of all the materials needed to make his furniture, as well as the labor costs, workshop space, and warehouse costs that were required to make each piece.
Throughout the year, Dale buys more raw materials and manufactures dozens more miniature furniture pieces. After adding all of these costs together, Dale arrives at a “purchases during period” amount of $60,000. At the end of the year, Dale has $25,000 worth of inventory left.
Dale then calculates his COGS by adding $50,000 and 60,000, which lands him at $110,000. Dale then subtracts $25,000 from $110,000, making his COGS $85,000.
To take it a step further, Dale subtracts his COGS from his net income of $200,000. This means that Dale made a gross income (or profit) of $115,000 that year. Not bad for a miniature furniture builder.
FIFO LIFO and Average Cost
As briefly mentioned above, the cost of goods and materials is changing all the time. This makes it extremely difficult for companies to determine the value of the specific items that they’ve sold. To make up for this, companies use one of three methods: FIFO, LIFO, or average cost.
FIFO method stands for first in first out and means that the company will assume that the oldest units are the first ones to be sold.
The LIFO method is the opposite of this and stands for Last In, First Out. This means, as you can probably guess, that newer units are the first to be sold. During times where the prices of materials are on the rise, this also means that the most expensive units are sold first.
The average cost is another term whose definition is pretty easy to guess. When taking the average cost method, companies simply average the price of all goods in stock, no matter when they were manufactured. Taking this approach helps steady COGS when materials and manufacturing costs see an increase.
COGS and Taxes
The IRS allows companies to deduct the Cost of Goods Sold for any products they manufacture or purchase in order to resell. So, while it may seem tedious, keeping track of your COGS can actually end up saving your company a solid amount of money on your return when tax season rolls around.
For smaller businesses, the calculations and descriptions listed above should be sufficient. However, for larger corporations with more complicated manufacturing processes, a tax professional should be consulted.
In general, the process of filing taxes will look different for every business, so if you are unsure about what and what does not qualify as a deduction, consulting a professional can be wise. In any case, staying on top of your inventory and finances will help the filing process run smoothly for both you and your accountant.
Wrapping It Up
In any situation, whatever you can do to lower your COGS, the higher your gross income will be as a result. Having unreasonably high COGS can be a red flag for investors, and might be a reason for them to turn you away.
Of course, it’s always important to maintain a balance of lowering your COGS, but creating a high-quality product and paying your employees respectable wages. By keeping track of your COGS, you can be sure to keep your accounting accurate and up to date and use that information to make smart decisions for your growing business.