Understanding Cost of Goods Sold

Running a business involves a number of different operating expenses, whether it’s licensing fees, rent, utility bills or other upkeep costs. As a business owner, it’s important to understand all of your incoming revenue as well as any outgoings so that you can try to maximize the former and minimize the latter. One important metric to get a better idea of this is cost of goods sold, sometimes known by the acronym COGS.

In a nutshell, cost of goods sold refers to the immediate costs of producing the goods that are sold by a company. That is, it is a measure of the cost of labor and materials used in order to create a product, and it does not include any indirect expenses. Keep reading to find out more about this important metric and how to calculate cost of goods sold.

What is cost of goods sold?

One of the first questions that comes up when people attempt to do accounting for a new business is “What is cost of goods sold?”. As previously mentioned, this refers to the direct costs implicated in the manufacturing of a product, and it excludes any indirect costs such as distribution, marketing and overheads.

For example, with a car manufacturer, the cost of any car parts and the labor used to assemble the car would be included within cost of goods sold. However, sending the car to the dealership would not be included in COGS.

When you look at your company’s financial statement, you will notice that COGS is deducted from overall revenue in order to calculate your gross profit. This means that the cost of goods sold will have an impact on your profit margins, with a high COGS resulting in a lower margin.

Since the cost of goods sold is considered an essential expense to your business, it is recorded as a business expense on any financial statements. This is important for income tax purposes, as by writing off your expenses in this way you will reduce the overall tax that your business needs to pay. 

How to calculate cost of goods sold

There is a simple cost of goods sold formula that you can use to calculate this metric, which is as follows:

The beginning inventory refers to the total value of the inventory at the beginning of the financial year, or at the end of the previous year. The cost of goods is the total amount of money that was spent on producing goods throughout the year, and the ending inventory is the value of the inventory at the end of the financial year.

Why is cost of goods sold important?

You might be wondering why it’s important to calculate cost of goods sold. Firstly, it gives you a better idea of the financial health of your business, and can help you to make decisions about where you could save money or where you need to invest more money.

One of the most important reasons why you need to know this figure is because it is actually a tax reporting requirement.  You will need to calculate cost of goods sold in order to write off these expenses, which in turn will benefit you as it will reduce the amount of tax you need to pay.

What’s more, if you can use the cost of goods sold formula to calculate COGS, you can get a better idea of how much you should be selling your products for. Choosing the right product price will allow you to cover your costs and give you a healthy profit margin, so make sure to determine this with COGS in mind.

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