A woman sits at a wooden desk and uses a calculator with her right hand. Her other hand rests on a laptop. In the background are shelves of boxes.
It's important to know your business's cost of goods sold, for both your own benefit as the owner and the benefit of prospective investors. — Getty Images/ake1150sb

Cost of goods sold (COGS) is an important metric that contributes to a business’s overall gross profit and long-term growth prospects. This KPI impacts everything from your tax rate to your pricing model and even your personal income. A high COGS can eat into your profit and slow growth, but it is a tax-deductible expense for most businesses. Here’s what you need to know about the cost of goods sold metric, including how to calculate it for your venture.

What is cost of goods sold?

Cost of goods sold (COGS) is a sum of all direct costs associated with selling a product or service. This includes things like materials and labor used to create the product, but not indirect expenses such as distribution costs or overhead.

COGS is an important metric that is included in a business’s income statement. It also impacts your taxes. “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,” said the experts at Freshbooks. “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.”

COGS will also play a role in how you price your products. Some pricing strategies start with COGS as the baseline, or minimum, price charged to the customer. The business owner will add a percentage on top of the COGS baseline to create a profit margin, as well as to cover indirect costs. This is another reason why it’s important to know your COGS.

[Read more: How to Price Your Product: A Step-by-Step Calculation]

Companies that make and sell products or buy and resell its purchases need to calculate COGS in order to write off the expense.


How to calculate COGS

COGS can be a little complicated to calculate. The first challenge is that the cost to make a product can change throughout the year. Inventory costs change accordingly. Therefore, there are three methods a company can use to record inventory sold over a certain time period are:

  1. FIFO: First In, First Out. This means the first, or earliest, goods to be purchased or manufactured are sold first.
  2. LIFO: Last In, First Out. This means the most recent goods to be purchased or manufactured are sold first.
  3. Average Cost Method. The value of the goods sold is determined by the average price of all the goods in stock, regardless of purchase date. “Taking the average product cost over a time period has a smoothing effect that prevents COGS from being highly impacted by extreme costs of one or more acquisitions or purchases,” explained Investopedia.

The basic calculation for COGS is: (Beginning Inventory + Cost of Goods) - Ending Inventory = Cost of Goods Sold.

Another option is to use change in inventory. For instance, if 200 units are made or bought, but inventory rises by 50 units, then the cost of 150 units is the cost of goods sold. If inventory decreases by 50 units, the cost of 250 units is cost of goods sold.

Perhaps the most difficult part is understanding which direct and indirect costs apply to your COGS. Most costs included in your calculation will be direct costs, but in some cases, you may be able to include a portion of your indirect costs. For instance, indirect costs such as overhead costs at the manufacturing site, distribution costs or supplies used to make or sell the product can sometimes be factored into your COGS. Direct labor can also be included, as long as you have the documentation to support your claim.

If you’re still unsure how to calculate COGS, try this free online COGS calculator and speak to a tax professional who can help.

[Read more: Amid Supply Chain Disruptions and Demand Shifts, Brands Rethink Pricing Strategies]

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