How to Calculate Cost of Goods Sold for Financial Statements

Cost of goods sold, also known as COGS or cost of sales, is a company's direct cost of producing goods sold to a distributor, retailer, or manufacturer during a given period. This cost is deducted from revenue or sales to determine a company's gross profit and gross margin—its sales revenues minus the direct cost of goods sold and the amount of gross profit generated by percentage.

From an accounting perspective, COGS is considered a business expense and is usually listed under sales or income on a company's income statement (or profit and loss statement), which reports income for an accounting period. The Internal Revenue Service (IRS) requires companies that make and sell products or buy and then offer those purchases for resale to provide COGS as part of their financial statement to write off that expense.

The purpose of cost of goods sold is to help a company determine its gross profits. In this regard, it's considered an important metric for businesses to understand how well labor and supply costs are managed in production. Additionally, the cost of goods sold reported by a company at tax time can determine how much they can write off as a business expense.

Figures that are a part of COGS include the cost of items intended for resale, direct labor costs, cost of raw materials, supplies used for manufacturing or sales of a product, and shipping, container, and freight costs.

Other factors, like indirect costs (or indirect expenses), distribution and sales force costs, and overhead costs, may not be considered part of the cost of goods, depending on the source. Additional factors such as operating expenses, like rent, utilities, and marketing costs, may also vary by basis.

There are two formulas used to calculate the cost of goods sold:

• Method 1: Take the beginning inventory, add it to the purchases made during that period, and subtract the ending inventory to determine the cost of goods sold. Beginning inventory is defined as the inventory that was leftover or not sold from the previous year, as well as any production or purchases for materials and labor directly used to manufacture or retail a company's goods. Ending inventory is described as current assets not listed as part of the beginning inventory. The COGS, then, is the cost of any items bought or made during the current year.
• Method 2: For this method, inventory changes are measured to determine COGS. For example, if 200 units are made or bought, but the inventory also rises by 50, then the cost of 150 units is the cost of goods sold.

Here is an overview of the COGS calculation process:

• Determine your costs. List all of the costs incurred by your products, whether you make them or buy and resell them, including direct costs (those related to buying or making the product) and indirect costs (storage, facilities, labor).
• Calculate your inventory. Your inventory includes the products you currently have in stock and the raw materials and supplies that will be required to make more. Add the shipping and manufacturing (or invoices) for any products added to your inventory and provide an estimated value for any damaged stock.
• Value your inventory. To determine the valuation of your stock, apply one of three accounting methods: first-in, first-out (FIFO), which measures value by the oldest items in your inventory; last-in, first-out (LIFO), which determines value by the newest items; and average cost, which simply tabulates an average price for each item, regardless of manufacturing date.
• Calculate to determine COGS. Finally, use all of this information to calculate COGS. Consider hiring a tax professional to tabulate this information or use a spreadsheet to detail the numbers. Regarding taxes, sole proprietors and single-member limited liability companies (LLC) use Schedule C, while partnerships, multiple-member LLCs, and S corporations use Form 1125-A.

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