As a small business owner, you’re probably more interested in growing your company than in bookkeeping and accounting. However, knowing how to read and interpret your financial data is essential to making sound business decisions. The cost of goods sold is one of the most important income statement line items to understand. Here’s what you should know about it, including what it is, how to calculate it, and why it matters. What is the cost of goods sold? The cost of goods sold, often abbreviated to COGS, refers to the costs directly involved in bringing your goods to market. In other words, it includes all the costs necessary to produce your offering. Typically, those are the following: Direct materials - These are the subsidiary components consumed to create your products. Direct labor - These are the wages and benefits paid to the workers who build your products. Manufacturing overhead - These are indirect costs necessary for production and incurred during the process. For example, let’s say you own a manufacturing business that produces furniture. Your direct materials would include the wood, screws, and other supplies used to create the products. Your direct labor costs are the payments made to the workers putting the pieces together. Meanwhile, your manufacturing overhead includes costs like utilities for the factory, depreciation on the production equipment, and insurance on the facility. Cost of goods sold vs. operating expenses. COGS only refers to the costs you incur to make your products or services ready for sale. These expenses go near the top of the income statement below your net sales, from which you subtract them to calculate your gross profit. COGS excludes the other expenses your business incurs in its day-to-day operations. Commonly referred to as operating or selling and administrative (SG&A) expenses, these costs aren’t directly related to production. They go below your gross profit on the income statement and include costs like rent, interest, and advertising. What is the cost of goods sold formula? The cost of goods sold may seem simple, but it can be surprisingly challenging to calculate in practice. Here’s the formula as it’s most commonly written: COGS Cost of Beginning Inventory + Cost of Goods Purchased or Manufactured – Ending Inventory This formula takes the amount you spend to acquire or produce your goods during an accounting period and adjusts it for the change in your inventory. It essentially works backward to find the cost of the goods sold. Fortunately, the cost of your beginning inventory is easy to obtain, as it equals your ending inventory from the previous period. You can get your ending inventory for the current period by performing an end-of-year count. Calculating the cost of goods purchased or manufactured involves more work, as it requires finding your direct labor, direct materials, and manufacturing overhead costs. However, once you have all these pieces, calculating COGS is straightforward. For example, say your business spends $55,000 on direct materials, $30,000 on direct labor, and $15,000 on manufacturing overhead during 2020. Its ending inventory from 2019 was $50,000, and your latest count shows a $40,000 ending inventory for 2020. The calculation for your COGS would be the following: $50,000 + ($25,000 + $20,000 + $5,000) – $40,000 $60,000 Accounting methods for COGS. Unfortunately, calculating your inventory’s value isn’t always as simple as counting the number of units on hand. Direct materials, direct labor, and manufacturing overhead costs tend to change over time, usually increasing. When that happens, you’ll have identical products with different costs. In this situation, you must choose an accounting method to determine which products you sold and which are still in your inventory. These accounting methods are known as cost flow assumptions and refer to which items you assume you've sold first. Here are the most common options: First-In, First-Out (FIFO) - This assumes you sell the oldest items in your inventory first. It leads to a lower COGS in a period of rising prices. Last-In, First-Out (LIFO) - This assumes you sell the newest items in your inventory first. It leads to a higher COGS in a period of rising prices. Weighted average - This involves calculating the weighted average cost of all items in your inventory and assigning it to each unit. It’s generally the easiest method. For example, say you manufacture 150 tables for $10 in July, 200 tables for $15 in August, and 100 tables for $20 in September. During the quarter, you sell 200 chairs. Under FIFO, you’d assume that the first 150 tables cost $10 and the remaining 50 cost $15. Using LIFO, you’d assume that the first 100 tables cost $20 and the other 100 cost $15. Finally, the weighted average method would assume all tables cost $14.44. Some businesses use the specific identification method to monitor their inventory costs, eliminating the need to make a cost flow assumption. However, that requires tracking the costs of each item in your inventory. It’s usually only viable for businesses that sell high-value products and only ever keep a small number of them on hand. Why do you need to know your cost of goods sold? At the very least, knowing your cost of goods sold is essential to creating your profit and loss statement, which you need to calculate your business’ income for tax filing and business financing purposes. However, your COGS also has significance as a specific line item. First, it’s typically your business’ highest expense, giving it a greater impact on your profits than any other costs. In addition, you must subtract COGS from sales to get your gross profit margin. When you divide that by your sales, you get your gross profit margin ratio, a critical profitability metric. It tells you the percentage of sales you keep after making your products ready for sale, but before accounting for operating costs. Comparing your gross profit margin to others in your industry is one of the best ways to assess whether your prices and COGS are where they should be. For example, say you currently have a 28% gross profit margin, but your three closest competitors average a 40% gross profit margin. That should raise some alarm bells for you. It indicates your prices are too low or you’re paying too much in COGS. In the case of the former, you should raise your prices to match your competitors. If the latter is true, you should find a way to reduce costs, such as getting a new materials supplier.