Attaining a high-profit margin is the goal for most businesses, right?
But to determine your profit margin, you’ll first need to figure out the amount of money required to develop your product or service.
In accounting, this is referred to as Cost of Goods Sold, or COGS.
How to calculate COGS
Crunching the numbers come tax season can be headache-inducing and sometimes intimidating. Fortunately, determining your COGS is pretty straightforward.
Cost of Goods Sold formula
(Beginning inventory costs + Additional inventory costs) - Ending inventory = Cost of Goods Sold
Here’s an example to further explain the above formula:
- Company A recorded $3.5 million worth of inventory at the beginning of the 2017 fiscal year.
- Company A spent $4.2 million in additional inventory costs over the course of the 2017 fiscal year.
- Company A recorded $2 million worth of total inventory at the end of the 2017 fiscal year.
($3.5 million + $4.2 million) - $2 million = $5.7 million COGS
The word “inventory” can be wide-reaching, and since COGS has tax implications, it’s important to specify what counts as inventory before calculating COGS.
What is inventory?
Many consider inventory the number of goods in a company’s stock, but when it comes to COGS, inventory is far more than that.
Here are the many factors of inventory.
Cost of raw materials
There are always costs associated with raw materials, as products cannot be developed freely.
For example, some of the most common raw materials used to produce sunglasses include:
- Metal, polycarbonate, or cellulose acetate for frames.
- Thermoplastics for lenses.
- Color and tint options for frames and lenses.
- Nose buds for comfort.
- Metal hinges and small screws for functionality.
In addition to the physical materials, there’s also the cost of running the machinery needed to assemble everything.
Cost of labor
Any employee associated with the direct production of a good or service is considered in the cost of labor. This doesn’t include your marketers, salespeople, financial analysts, and other indirect laborers.
It’s important to make the above distinction for an accurate assessment of your COGS.
Cost of purchases
Purchases will be made throughout a fiscal year when adding to your total inventory. These purchases are everything after your beginning inventory and must be factored in for an accurate assessment of your COGS.
Any expense that hasn’t been listed above, yet can be directly associated with the cost of producing a good or service is considered an additional cost. This includes:
- Cost of rent for maintaining a factory or warehouse.
- Cost of utilities such as water and electricity used for production.
- Costs of shipping materials and supplies used to produce your goods.
Now that you’re aware of what qualifies as inventory and know the COGS formula, it’s time to understand why this metric is important.
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Importance of Costs of Goods Sold
Simply put, you cannot determine your company’s profitability until the COGS is calculated. This is called gross profit and is produced by subtracting COGS from total revenue.
Another more tax-intensive reason why you should keep track of COGS is that it’s considered a business expense and is listed on the income statement.
Companies may be able to deduct the cost it takes them to produce goods or services, however, this isn’t applicable to everyone.
For example, companies that are capital-intensive (like manufacturing and mining) are more likely to tap into these deductions. Companies that are strictly service-based like doctors and lawyers typically never list COGS without a physical product to sell.
There’s also dealing with the Internal Revenue Service (IRS) and its auditors, who will analyze everything from purchase orders to employee records in search for red flags.
Finally, calculating COGS is important for companies in highly competitive markets. For example, COGS can signal pain points in the production process – which can point to easy wins, such as finding cheaper distributors of raw materials.
Reducing your COGS leads to better net income, or the total amount of money left after COGS, taxes, and other expenses are factored. More net income equals a better outlook for a company’s shareholders.
COGS also allows for you to calculate other KPIs for your inventory, such as inventory turnover.
Find your COGS
While you should utilize your accounting software when it comes to figuring inventory, it’s advisable to meet with a CPA or tax professional to determine the many sources of money spent on developing your product or service.
In the meantime, performing a basic calculation using the COGS formula could give you a good overview of where money is being allocated.
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