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6 Min. Read

What Is Cost of Goods Sold (COGS) and How to Calculate It

Cost of Goods Sold (COGS) is the cost of a product to a distributor, manufacturer or retailer. Sales revenue minus cost of goods sold is a business’s gross profit. Cost of goods sold is considered an expense in accounting and it can be found on a financial report called an income statement. There are two way to calculate COGS, according to Accounting Coach.

In this article, we’ll cover:

NOTE: FreshBooks Support team members are not certified income tax or accounting professionals and cannot provide advice in these areas, outside of supporting questions about FreshBooks. If you need income tax advice please contact an accountant in your area.

What Is Cost of Goods Sold (COGS)?

Cost of Goods Sold are also known as “cost of sales” or its acronym “COGS.” COGS refers to the cost of goods that are either manufactured or purchased and then sold. COGS count as a business expense and affect how much profit a company makes on its products, according to The Balance.

Cost of goods sold is found on a business’s income statement, one of the top financial reports in accounting. An income statement reports income for a certain accounting period, such as a year, quarter or month.

COGS is usually found on an income statement under the category “sales” or “income.” An income statement is also called a “profit and loss statement.” Here’s an example:

profit and loss statement

Source: FreshBooks

COGS and Taxes

Cost of goods sold is actually a tax reporting requirement. Companies that make and sell products or buy and resell its purchases need to calculate COGS in order to write off the expense, according to the IRS. This decreases the total amount of taxes they need to pay.

Small businesses with an average gross revenue (before costs or expenses) of less than $25 million in the past three tax years report cost of goods this way. They must keep complete and accurate accounting records to prove these costs.

To do this, a business needs to figure out the value of its inventory at the beginning and end of every tax year. Its end of year value is subtracted from its beginning of year value to find cost of goods sold. The below section deals with calculating cost of goods sold.

Higher cost of goods sold means a company pays less tax but it also means a company makes less profit. Something needs to change. Cost of goods should be minimized in order to increase profits.

What Is Included in Cost of Good Sold?

The items that make up costs of goods sold include:

  • Cost of items intended for resale
  • Cost of raw materials
  • Cost of parts used to make a product
  • Direct labor costs
  • Supplies used in either making or selling the product
  • Overhead costs, like utilities for the manufacturing site
  • Shipping or freight in costs
  • Indirect costs, like distribution or sales force costs
  • Container costs

What Is the Cost of Goods Sold Formula?

Method One

Cost of goods sold is calculated using the following formula:

(Beginning Inventory + Cost of Goods) - Ending Inventory = Cost of Goods Sold

The beginning inventory is the value of inventory at the beginning of the year, which is actually the end of the previous year. Cost of goods is the cost of any items bought or made over the course of the year. Ending inventory is the value of inventory at the end of the year.

This formula shows the cost of products produced and sold over the year, according to The Balance.

This free cost of goods sold calculator will help you do this calculation easily.

Method Two

Cost of goods made or bought is adjusted according to change in inventory. For example, if 500 units are made or bought but inventory rises by 50 units, then the cost of 450 units is cost of goods sold. If inventory decreases by 50 units, the cost of 550 units is cost of goods sold.

Uses of COGS in Other Formulas

Cost of goods sold is also used to calculate inventory turnover, a ratio that shows how many times a business sells and replaces its inventory. It’s a reflection of production level and sell-through. COGS is also used to calculate gross margin.

Handling Inventory Cost Changes

The price to make or buy a product to resell can vary during the year. This change needs to be dealt with in a way that satisfies the IRS. There are three methods:

  1. FIFO: or “first in-first out.” The first goods made or purchased are the first sold.
  2. LIFO: or “last in-first out.” The last items made or purchased are the first sold.
  3. Average cost: average cost per item is calculated.

Cost of Goods Sold Example

An e-commerce site sells fine jewelry. To find cost of goods sold, a company must find the value of its inventory at the beginning of the year, which is really the value of inventory at the end of the previous year.

Then, the cost to produce its jewelry throughout the year is added to the starting value. These costs could include raw material costs, labor costs and the cost to ship to jewelry to consumers.

Finally, the value of the business’s inventory is subtracted from beginning value and costs. This will provide the e-commerce site the exact cost of goods sold for its business, according to The Balance.

People also ask:

Is Cost of Goods Sold an Asset?

Cost of goods sold is not an asset (what a business owns), nor is it a liability (what a business owes). It is an expense. Expenses is an account that contains the cost of doing business.

Expenses is one of the five main accounts in accounting: assets, liabilities, expenses, equity and revenue.

Expenses are recorded in a journal entry as a debit to the expense account and a credit to either an asset or liability account.

If using the accrual method, a business needs to simultaneously record the cost of goods and the sale of said goods. Then the expense is said to be “matched,” according to Accounting Coach.