Cost of goods sold (COGS) is how much it costs to produce your business products or services. COGS summarizes the aggregate of all the costs it takes-including inventory, raw materials, labor, and wages-to bring your consumer goods or services to the market.
In order to turn a profit, you need to make sure your COGS is lower than the dollar amount your business charges customers to buy your goods or services.
If your business purchases products to resell and maintain inventory, the COGS accounts for the costs of items purchased for resale. If your business manufactures products, the COGS formulation is more complex, since you must account for all raw materials and labor costs which go into production. In short, COGS is an accounting term for the actual cost of your marketable business products or services.
Why Calculate Cogs?
Understanding fluctuations in your COGS can help you determine the value of your business. Your COGS is directly linked to your business profits; keeping tabs on your COGS will help you monitor the financial health of your business.
Your COGS measures whether the pricing of your products and services are appropriate for the market. COGS can also give you a picture of what kind of sales your business will need to generate in order to grow, and whether your pricing model is on par with market demands. COGS is often your largest business expense, so these numbers are essential for monitoring your income and cash flow, as well as for determining your gross profit margin.
Calculating COGS With the Small Business Inventory Model
Start with the value of your inventory at the beginning of the month (or quarterly, depending on your accounting practices). Add the inventory purchases made during that month, and subtract the value of remaining inventory at the end of the month.
This formula accounts for the dynamic ebb-and-flow of your business inventory over a short period of time. In simple equation form, it looks like this:
Beginning Inventory + Inventory Purchases – End Inventory = Cost of Goods Sold (COGS)
How do we put this equation to the test when considering a real world small business example? Let’s consider a clothing boutique which has a revolving inventory and seasonably changing goods.
The clothing boutique might begin the month of April with $50,000 in inventory (clothing and accessories), then purchase $25,000 in additional inventory during the month (the new summer line), and may end the month with $40,000 in inventory (a strong month due to sales of winter items plus sales of the new seasonal summer stock).
Let’s plug in these numbers: To calculate the COGS, we would begin with $50,000 (beginning inventory) + $25,000 (additional inventory purchases) – $40,000 (end inventory) = $35,000 (total costs of goods sold (COGS)).
Note that the gross margin for that time period is positive, which means a solid business month. Revenue which is less than the COGS would indicate a financially challenging month for the business. If revenue continued to be less than the COGS over several months, interventions such as increased pricing or reducing business expenses and overhead should be considered.
Calculating COGS With the Manufacturing or Production Model
This formula may be a bit more complex since you need to include the sum of all of the direct costs of production, such as the costs of labor, raw materials, and supplies. Direct costs are all costs used to create your products or services.
Continuing with our clothing example, a clothing manufacturer would need fabric, thread, sewing equipment, and labor to create garments; all of these would be examples of direct costs of production. Indirect costs are business expenses which are not directly related to bringing your products or services to life, such as advertising costs or salaries paid to non-production employees.
In simple equation form, you can calculate the COGS for manufactured goods as follows:
Cost of Goods Manufactured + Opening Finished Goods Inventory – Ending Finished Goods Inventory = Cost of Goods Sold (COGS)
The classification of “direct costs” versus “indirect costs” may be somewhat subjective. Such costs are a case-by-case determination based on the unique nature of your business. These costs are also subject to fluctuations based on market changes, and therefore it is a sage decision to review the details with a tax professional to ensure all appropriate classifications and deductions for your business.
As you can see, COGS isn’t the only consideration when it comes to pricing your products. You will have to take into consideration other expenses such as real estate costs or rent, employee overhead, marketing, and other professional fees and services you must pay to keep yourself in business. However, COGS is an important element to understand when it comes to growing your bottom line and remaining profitable.