Understanding Cost of Goods Sold

By: First Union | Date:

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Understanding Cost of Goods Sold

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For businesses that sell actual products, you need to understand how to calculate the cost of goods sold. Essentially, this number involves everything and anything that is spent to sell your products. Depending on the nature of your products (meaning, if they are manufactured by you versus having been purchased from a wholesaler/) arriving at the cost of goods sold (COGS/) can get to be a little more complex. In this article, we will look at what exactly the COGS entails and how you arrive at a calculation of this number.

Dealing with Inventory

Your business's inventory is that which you sell to customers. The cost of goods sold is directly related to your inventory. There are a couple of types of inventory that will necessitate different ways of calculating the COGS. First off, there is that which you purchase from a wholesaler and then sell to the end-user. There is also inventory that you produce and consequently sell. Additionally, there is an inventory you buy that enables you to manufacture your product. Inventory is considered an asset and accordingly given value to that end.

A business will periodically "take inventory." This is almost always done, at the very least, at the beginning of the year and again at year's end. To effectively calculate the COGS, you have to be sure to do this.

The COGS Calculation

You will first need to gather some important information regarding your business's inventory to perform the COGS calculation.

  • What is your beginning inventory? You have to figure out the value of any supplies and/or materials used in conjunction with your products. The number you arrive at, needless to say, should match that of the previous year's end.
  • How much did it cost you in parts, materials, and finished products for your inventory?
  • You will also need to factor in the cost of labor; in other words, you had to pay employees to make/ship products, so you need to know what that total expense came to.
  • Beyond just the cost to manufacture the products, you have to figure in the expense associated with shipping and delivering your items.
  • Any other costs you can think of connected to the final delivery of your product, so warehousing, for example, freight costs, even electricity associated with storage, and so forth.
  • What is the value of your ending inventory: the total inventory value when calculated at year's end.

So the basic formula for arriving at the COGS involves beginning inventory value, plus purchases and all other associated costs; you then subtract the ending inventory value and that is when you arrive at the cost of goods sold.

For example, consider the following:

Your initial, beginning of the year value of all inventory totals 20,000. You've determined that you spent 11,000 on materials and other costs to create, sell, and ship the products. Your end of the year inventory value is 14,000. So this means that the COGS is 17,000.

A Breakdown of the COGS Calculation

Figure Out All Associated Costs (Direct and Indirect/)

This particular calculation requires that you do deduct all costs connected to selling your products. Even if you buy from a wholesaler and resell, you still need to factor in things such as labor, warehouse, and general supplies. Involved with this formula are 2 primary types of costs: direct and indirect. Direct costs are those connected to the actual making of the product or the purchasing of the finished product. Indirect are costs associated with things such as warehousing, shipping, and labor.

Labor can furthermore be broken down. For instance, there are direct labor costs, such that you pay to workers who make or are involved in the purchase of the product. There are also indirect labor costs that are paid to those responsible for tasks such as stocking and shipping.

What Are Your Facility Related Costs

These can be a bit more difficult to figure out. You are trying to arrive at what you pay about your buildings and all relevant locations. You have to arrive at a percentage of what you spend in rent, utilities, taxes, and interest and assign this percentage to the products for a specific period—generally one year.

Arriving at the Value of Your Beginning Inventory

So this will include all merchandise that you have in stock at the beginning of the year. And it is not just the finished products, you also want to account for raw materials, partially finished products, and any supplies that are involved with the items you sell. This is what taking inventory is all about as most businesses require one or more employees to go through and count the items in inventory. Again remember, this value should be the same as what you arrived at after the previous year.

Don't Forget Any Purchases of Inventory Items

Throughout the year you will probably add inventory. You want to keep a running count of this. Keep track of shipment costs, manufacturing expenses as well as any storage costs. You will then factor this number into the value of your inventory.

Arriving at the Value of the Ending Inventory

Again, here you will likely need to take a physical inventory to see where you are currently at. With your ending inventory, you can take off for products that are damaged and/or obsolete. For both, you are going to have to show evidence that it was damaged and therefore its value has decreased, or that it is no longer a relevant product and consequently has less value.

Do Your COGS Calculation

After having gathered all the necessary information, you are ready to figure out the COGS using the calculation noted above. Some enlist the help of an accountant or tax professional as you will have to input this calculation on your business tax returns. It is always better to be safe if you are uncertain and hire someone to help you with this.

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