Cost of Goods Sold (COGS) includes all direct costs used during the production or acquisition of goods and inventory sold by a company. As a small business, understanding COGS can help you run a more efficient and profitable company.
The main components of COGS are the direct expenses incurred such as production costs, inventory acquisition expense, labor, and raw materials. Indirect costs such as marketing and distribution are not included in COGS.
How to Calculate COGS
In the accounting sense, COGS is calculated using the formula (Beginning Inventory Costs + Cost of Manufacturing New Inventory/Acquiring New Inventory) – Ending Inventory = COGS.
If your business manufactures the inventory it sells, you may be able to include warehousing expenses and machinery leasing costs in your COGS. If you are a reseller, you can include the cost you incurred to acquire the inventory. After calculating the costs of the inventory acquired or made during the period, you add it to net inventory at the end of a period to determine the COGS.
For instance, if you started the year with $1,000 in inventory and acquired $5,000 of goods during the year and were left with $3,000 in inventory at the end of the year, COGS would be calculated as ($1,000 + $5,000 – $3,000 = $3,000).
Because every company is different, calculating COGS requires an understanding of your business operations and the intricacies of accounting and tax law. Therefore, the best way to ensure that you calculate COGS correctly is to contact a local CPA Firm to assist.
Why is COGS Important?
Cost of Goods Sold (COGS) is a component of the Income Statement and plays a major role in calculating your Net Income. Determining COGS is an important step in understanding the profitability of a business, and it can have a major effect on your taxable income.
To take advantage of the COGS deduction on your tax return, you’ll need to keep meticulous records throughout the year of all required manufacturing and inventory expenses incurred during the production or acquisition of sold goods.
The CPAs at Rivero, Gordimer & Company have experience calculating the Cost of Goods Sold for various businesses and industries. With the help of a tax expert, you can make sure that all eligible costs are included in your COGS which will lower your taxable income and reduce your business’s tax bill.
COGS isn’t just important for calculating your taxable income; it can also provide insight into the health of a business. We know that COGS is used to determine Net Income, but it can also be used to calculate the Gross Profit Margin.
The Gross Profit Margin, or Gross Margin, is calculated by the formula (Revenue – COGS) / Revenue = Gross Profit Margin.
Gross Margin is a useful ratio for business to see whether they are earning more than they spend on inventory. In the simplest sense, this shows the financial health of business operations.
For instance, if a company’s Gross Profit Margin goes from 80% one period to 30% the next, that could indicate that they have inefficiencies in production or that they have issues in the sales process. While the Gross Profit Margin formula won’t indicate exactly where issues are, it can show red flags that will require more strategic analysis.
Understanding COGS is an Important Practice
Every business needs to track and understand their Cost of Goods Sold. Even if your business offers a service and not goods, it has a Cost of Services or Cost of Sale (COS) that needs to be calculated.
COGS is used to calculate taxable income, to shed insight on a business’s profitability, and can be used to make strategic business decisions.
If you need help calculating COGS for your business, reach out to the tax experts at Rivero, Gordimer & Company.