Have you ever thought about how much it costs you to produce and sell your products?
As an entrepreneur, knowing the answer is crucial since this cost will have a significant impact on your business profitability. Let’s take a look at the so-called cost of goods sold (COGS) and explore ways to achieve your ultimate goal: to keep your COGS as low as possible.
What is the Cost of Goods Sold?
If you own a business, you need to know this amount for several reasons.
First, COGS may need to be included in your business’s tax return. Single-member LLCs and sole proprietorships report the cost of goods sold on Schedule C. Because COGS can reduce business income on a tax return, it’s something you definitely want to keep track of.
Another reason is that once you know your cost of goods sold, you’ll be better able to price products correctly so that you can achieve a good profit margin.
How do You Calculate Cost of Goods Sold?
Now that you understand the importance of COGS, it’s time to look at how to calculate it.
To determine the cost of goods sold for your tax return, you may want to use a professional accountant or tax preparation software. But for a weekly or monthly calculation, you can do it yourself following these steps:
Cost of Goods Sold Formula
A very easy formula can be used to calculate COGS over a specific period, such as annual, quarterly, or monthly. It is simply:
COGS = Beginning inventory + Purchases made during the period – Ending inventory
Let’s look at an example. Say a steakhouse starts the month with $27,000 in inventory, makes purchases of $18,000, and ends the period with $21,000 of inventory. In this case, the cost of goods sold is $24,000 ($27,000 + $18,000 – $21,000).
If you own a restaurant, use the Food Cost Formula to calculate your COGS.
Elements of the COGS Formula
- Beginning inventory: The inventory at the start of the period is simply the inventory that was leftover from the previous period. It is the ending inventory used in the previous period’s calculation.
- Purchases made during the period: Only those purchases made during the period that relate to the actual production or manufacture of goods should be included in the COGS calculation. For instance, the cost of goods for a restaurant would include ingredients and labor that go into the preparation of food, but would not include advertising costs.
- Ending inventory: Once again, this is simply the inventory the business has at the end of the reporting period. The exact amount can be reduced by worthless, outdated, or damaged inventory. Records must be kept for items that meet one of these definitions. Obsolete inventory (obviously, we are not referring to food) could be donated to charity.
Methods to Calculate Your COGS
There are three accounting methods a business can use to determine the value of COGS:
- First in, first out: Also known as FIFO, this method assumes that the first goods to be manufactured or purchased are sold first. In a period of inflation, a business that uses FIFO will sell more expensive products later. This leads to a lower cost of goods sold.
- Last in, first out: With the LIFO method, the most recent products added to inventory are the items sold first. This means that in times of inflation, if more expensive items are sold first, that will produce a higher COGS.
- Average cost method: With this accounting system, the average price of all products in inventory is used without considering the date they were brought in. By using the average cost over some time, COGS tends to be consistent without significant fluctuations due to periodic large purchases.
What Does COGS Tell You about Your Company
The cost of goods sold is used to determine a business’s gross profit. This number is merely total revenue minus COGS:
Gross profit = Total revenue – COGS
The calculation will be shown on a business’s income statement. In the restaurant industry, COGS should be less than 31% of revenue.
Gross profit is used to calculate operating profit in this manner:
Operating profit = Gross profit – Operating expenses
The higher the operating profit and gross profit, the better the business is doing. Thus, you want COGS to be as low as possible.
What Expenses Should Be Included in COGS?
There are three main categories of expenses that cost of goods can be divided into materials, overhead, and direct labor.
For businesses that sell mostly services, COGS will be things like payroll taxes and employee salaries. For a restaurant, the cost of ingredients (and the cost to ship them to the restaurant) should be included. Also, the cost to store the ingredients are considered part of COGS. And of course, the labor to prepare the ingredients and deliver them to customers is included.
Is Cost of Goods Sold Variable or Fixed?
Both fixed and variable expenses are part of the cost of goods sold, although the vast majority of items in COGS are variable expenses. Fixed costs are items like overhead, including utilities, equipment, and taxes.
Depreciation of equipment, whether in a restaurant or a manufacturing plant, is another fixed cost. Although labor costs can vary from time to time, because they are a regular expense, they are considered fixed.
Keep in mind that selling, general and administrative (SG&A) costs are not part of COGS.
What is the difference between COGS and expenses?
Don’t confuse these two, as they are quite different.
- COGS, as it names hints at, is just the cost of the goods you sell. This means it only takes into consideration the associated expenses of producing your products.
- Expenses, on the other hand, are all costs, including those associated with running the business.
Tips to Reduce Your COGS
To reduce your COGS, you can:
- Cut down on labor costs
- Scale back production costs
- Comparison shop. Some suppliers may offer lower prices than others
- If you run a restaurant, accurately measure ingredients during food preparation
- Also for restaurants, categorize your food expenses
Learn how to negotiate with your suppliers. By getting cheaper prices, your COGS will decrease.
Instead of viewing COGS as a headache, look at it as something manageable—something that can actually translate into a benefit during tax season. When you learn to use and control COGS, your business’s profit margins will get better.