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When you run a business that sells any product or service, the cost of goods sold (COGS) is an essential metric. Cost of goods sold is a major input in overall profitability, so understanding how COGS works and flows into your business results is vital for any business owner or manager.
If you want to know how cost of goods sold works, take a look at the cost of goods formula and learn how you can put cost of goods sold to work to help improve your long-term business outcomes.
What is cost of goods sold?
Cost of goods sold is the total amount your business paid as a cost directly related to the sale of products.
Depending on your business, that may include products purchased for resale, raw materials, packaging, and direct labour related to producing or selling the good.
In other words, the materials that go into the product and the labour that goes into making each unit may be included in cost of goods sold. If you incur sales costs specific to that item, like commissions, those costs may also be included in COGS. The accounting term for this is direct costs.
If a cost is general for your business, like rent, a new machine, or general marketing costs, it isn’t a cost 100% dedicated to a specific item. Those indirect costs are considered overhead, not the cost of goods sold.
Cost of goods sold is an important number for business owners and managers to track. That is the absolute lowest price you can sell a product to break even. Any additional margin goes back to covering overhead and eventually profit. If you don’t know your COGS and break-even point, you don’t know if you’re making or losing money.
Cost of goods sold is a major input in profit and loss statements, which are typically called income statements by large corporations. The terms “profit and loss statement” and “income statement” are used interchangeably.
Calculating cost of goods sold
Accountants and bookkeepers use a standard formula to calculate cost of goods sold for physical products:
Beginning Inventory (stock) + Purchases – Ending Inventory = Cost of Goods Sold
If you have any manufacturing labour costs or direct sales costs, you can include those as well, but that may not apply to all businesses.
Inventory costs may be a little more complicated to calculate depending on your business’s inventory method. If you use LIFO “last-in, first-out” or FIFO “first in, first out”, for example, the costs you include may vary.
Cost of goods sold examples
Cost of goods sold may also be referred to as “cost of sales.” Some public companies are required by law to share this information in their annual reports, so you can look at cost of goods sold, or cost of sales, for those listed on the Australian stock exchange.
Here’s a hypothetical example for a small business, calculated using the standard cost of goods sold formula:
Beginning Inventory + Purchases – Ending Inventory = Cost of Goods
Beginning Inventory: $15,000
Goods Available for Sale: $35,000
Less: Ending Inventory: ($10,000)
Cost of Goods Sold: $25,000
Learning from cost of goods sold
To get more comfortable with your business’s numbers, think of your business in these ways to better understand your COGS.
- Cost of goods sold is a major contributor to margins: Your business will never make money if cost of goods sold is higher than your product pricing. Always track COGS to help ensure you generate an operating profit.
- Get a fine-tuned understanding of COGS: Don’t just look at the high-level COGS result. Look at every underlying cost for savings opportunities.
- Strategically reduce cost of goods sold: Even small progress on COGS leads to higher profits. For low-margin businesses like restaurants and general retailers, a small difference in COGS can make or break your business.
- Keep a long-term focus: Take care to avoid making cuts that harm your customer experience, product quality, or employee experience, as they could turn around and harm your long-term outlook.
You don’t need a strong financial background to use COGS to build a more profitable long-term business strategy. Anyone can use COGS to improve their business.
Using cost of goods sold to improve profitability
Large companies hire teams of accountants and FP&A “financial planning and analysis” analysts to review every cost with a fine-tooth comb. While you may want to seek professional help, you can do your own calculation and but it still likely has opportunities to improve through your own COGS analysis. Businesses that use Square have quick access to this information on the Square Dashboard with analytics, inventory, and other reporting tools.
When you know what makes up your business costs, you can take steps to keep them under control and work toward your growth and profitability goals. Whether you’re trying to create or maintain a business to support your family or set yourself up for retirement, COGS is almost certainly part of the formula. With a good understanding of how it works, you are in better control of your company’s destiny.