When you first started operating your business, determining your costs and profits likely seemed straightforward. It’s just like your childhood lemonade stand days—you have $5 and spend it on sugar and lemons to make lemonade so that you can sell 10 glasses at $1 to double your money.
However, launching a full-fledged business is much more complex, even if you’re still making lemonade. One financial metric, the cost of goods sold (COGS), can help you keep track of profitability and guide your strategic decision-making process.
Follow this guide to calculate the cost of goods sold and learn how it can help you run a more successful business.
What is the Cost of Goods Sold?
You may see the full phrase “cost of goods sold” on your financial reports or simply see its acronym (COGS). This financial measurement refers to how much it costs to produce your goods and services. It includes expenses like direct materials and labor, which can quickly add up if you have a complex product.
The cost of goods sold doesn’t relate to all your expenses. It only references the cost directly connected to the production of your physical goods or services sold to customers. COGS do not include overhead expenses like marketing costs, shipping, or utilities.
For example, a company that manufactures and sells ceramic mugs online would include the cost of the clay, the paint, any mug accessories, boxes for the mugs, and the labor to assemble them. However, the COGS report wouldn’t include the electric bill for the kiln, the budget spent on social promotions, or the shipping costs.
What is the Cost of Goods Sold Formula?
The formula for cost of goods sold is straightforward. The 3 elements you need to know are:
- The beginning inventory at the start of the year.
- The cost of materials and supplies used to make your products.
- The inventory at the end of the year.
COGS = (Beginning Inventory + Cost of Materials and Supplies) – Ending Inventory
Using the ceramic mug example, if the business had $10,000 in inventory at the beginning of the year, invested $5,000 in materials, and sold $8,000 in inventory by the end of the year, then the calculation would be:
COGS = ($10,000 + $5,000) – $8,000
COGS = $7,000
This calculation may seem simple at face value, but the challenge of keeping track of your inventory and manufacturing expenses will vary widely depending on your industry. A small retailer will have a much easier time tracking its inventory and the cost of goods than an airplane manufacturer like Boeing.
In the latter industry, the labor costs are more in-depth, the costs of goods vary by different parts of the plane, and various planes require different COGS sheets.
For a better understanding of what is included in the COGS and what isn’t, consider the formula shared by the IRS:
COGS = (Inventory at the Beginning of the Year + Net Purchases + Cost of Labor + Materials and Supplies + Other Costs) – Inventory at the End of the Year
This formula essentially says the same thing as the previous one but draws out each additional expense that you need to take into consideration.
Why Do You Need to Know Your Cost of Goods Sold?
There are many benefits to calculating your COGS each year beyond its requirement for your tax forms. You can use this financial metric to evaluate the health of your business and adjust to increase profits.
First, you can use your COGS to set better prices. You can set your product prices at a level where you make more profit and increase your gross margin. COGS gives you an informed baseline for how much you need to charge to break even. From there, it’s up to your market research to determine how high your prices can go before you start to lose customers.
Next, you can look at your expenses and see if there’s any flexibility in lowering your materials expenses. You may be able to find a vendor who can provide materials for less or modify your manufacturing to eliminate unnecessary or costly materials.
Consider a local canning company as an example. The owner might realize through her COGS report that she needs to sell their jam for a minimum of $4 per jar, but customers won’t pay more than $6 for it. As a result, she would set jam prices at $5 per jar. Then, if she finds a different fruit vendor or speeds up the process to cut back on labor, she may save on the cost of materials. This change lowers the company’s manufacturing cost to $3.50, increasing its profits at $5 a jar.
Good Records Lead to Better Business Management
You can make some decisions as a business owner with your gut. However, most of your choices can and should come from data. Keeping track of your COGS and other financial aspects of your brand will help you stay profitable and make decisions that increase your profits without sacrificing quality. Plus, you can rest easy knowing your choices were made based on facts and calculations rather than blind assumptions and hope.