If you are a business owner selling products, it is crucial to understand the cost that comes with producing and creating those products. This is why we've compiled this short guide to the cost of goods sold and how to calculate it.
Cost of goods sold - explained
The cost of goods sold (COGS) describes the costs incurred when producing the product your business sells to its clients. If you are selling physical goods, this is likely to be made up of the value of existing inventory added to any related materials and direct labour cost incurred over a time period. Packing and transportation costs may also be included. COGS is a relevant metric for any company wishing to calculate cost of the products they sell - eg the service industry mostly does not use this concept. Digital products, however, can have COGS.
As a general rule, if costs are direct costs of creating a product, they should be recorded under the cost of goods sold. Any costs not directly attributed to the creation of a product, but still related to the generation of revenue, are recorded under operating expenses. This is often referred to as selling, general and administrative expenses.
How to calculate the cost of goods sold
The formula for cost of goods sold is as follows: Starting inventory + purchases − ending inventory = cost of goods sold.
This formula relies on a consistent approach to valuing your inventory and accounting for your (fixed) costs.
If your company is new, valuing your beginning inventory can be done either by its purchase price or by the cost of goods formula. Using the cost of goods formula, as a new business, you would use a value of zero for starting inventory. You can value your inventory either by "first in, first out", "last in, first out" or "average cost method". "First in, first out" works on the assumption that a company would sell old products before new ones. With prices rising over time, this would mean the business is selling its more affordable products first. "Last in, first out" assumes the opposite. The "average cost method" is designed to eliminate the effect of inflation by valuing inventory based on the average price of all goods currently in stock. Whichever method you prefer to value your inventory, you should stick to the one. Also, do not forget depreciation and amortization.
Managing a business expense
If you wish to account for an expense, there are two ways to do so. Firstly, using the cash method, you allocate the cost of the purchase to the day it was paid. This is simple but can be misleading, as you may receive the revenue a long time after the expense was recorded, Secondly, with accrual accounting, expenses only get recorded once they are fixed. While this is more complicated, it gives you a better idea of your company's financial performance.