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6 Min. Read

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

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 ways 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 your tax advisor. If you don’t have a tax advisor, find one that fits your needs through Taxfyle.

What Is Cost of Goods Sold (COGS)?

Cost of Goods Sold is 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 counts as a business expense and affects how much profit a company makes on its products.

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 directly beneath “sales” or “income.” An income statement is also called a “profit and loss statement.” Here’s an example:

Source: FreshBooks

COGS and Taxes

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

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.

A 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

At the beginning of the year, the beginning inventory is the value of inventory, 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.

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

Method Two

The 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, which shows how many times a business sells and replaces its inventory. It’s a reflection of production level and sell-through. The formula for calculating inventory turnover ratio is:

Cost of Goods Sold / Average Inventory = Inventory Turnover Ratio

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 to satisfy the IRS. There are four methods:

  1. Specific Identification: This method is generally used for very high-dollar products to match the actual costs to the specific items in inventory.
  2. FIFO: or “first in-first out.” The first goods made or purchased are the first sold.
  3. LIFO: or “last in-first out.” The last items made or purchased are the first sold.
  4. Average cost: average cost per item is calculated.

You can learn more about these inventory valuation methods and the rules for using them in IRS Publication 538.

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 shipping to jewelry to consumers.

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

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.

Reviewed for accuracy by Janet Berry-Johnson, CPA.

More Resources on Small Business Accounting

Straight Line DepreciationFIFO MethodBusiness Expenses
Debit vs CreditHow To Calculate Total AssetsBusiness Expense Categories
Income StatementNet Operating LossWhat is a write-off?
Break Even Point FormulaRetained Earnings FormulaGross Profit Margin Formula

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