Managing Cost of Goods Sold

Dec. 20, 2021

If you’re running a small business, you’ve probably heard of the cost of goods sold or COGS. Knowing what this is and how to manage it is important for your business. It helps you analyze your expenses and income, make plans for the future, get tax deductions, and more.

Here we’ll discuss what COGS is, how to manage it, and why it’s essential for your business.

What Is the Cost of Goods Sold?

COGS is the value of making or acquiring goods or services you sell during a certain time. It includes, but isn’t limited to, the cost of labor, the material needed for making the goods or providing services, and the utilities used for production.

COGS can be calculated only for the products or services you sold. It doesn’t include the inventory you still have.

By establishing COGS, you can calculate your overall income, see how successful your business is, and plan business growth and further development. Besides that, it helps you determine the pricing of your product or service and establish how much it should cost to make a profit.

How to Calculate COGS?

The formula for calculating COGS is simple. But before assessing it, you need to know the value of your inventory. This means calculating all the costs incurred in the process of getting your product or service ready:

  • The cost of materials
  • Packaging costs
  • Labor costs
  • Utilities
  • Rent

Once you establish the total value of your inventory, look at the amount you’ve sold. When you have that information, you’re ready to calculate your COGS:

This is the formula for doing so:

Beginning inventory + Purchases of inventory – end inventory.

Let’s say your clothing store had a beginning inventory of $60,000. Inventory purchases were $65,000, and you had $45,000 left at the end. This would be the formula:

60,000 + 65,000 – 45,000 = 80,000 (COGS)

You can always determine the cost of an individual product by using one of the three methods:

  • First In, First Out (FIFO) – In this case, you assume that the first product in your inventory is the one that will sell first. Depending on inflation and deflation, you may choose an inventory costing method that will suit your needs the best. During inflation, you assume that the products that cost less will sell first. When prices increase, the income will increase, too. This method may result in lower COGS during inflation. On the other hand, during deflation, you’ll most likely have a higher COGS.
  • Last In, First Out (LIFO) – Here, you assume the last items in your inventory will sell first. This method has the opposite effects of FIFO. Namely, during inflation, the COGS will be higher. During deflation, the COGS will be lower.
  • Average Costs – With this method, you calculate the average cost per product unit. Add the value of purchases to the beginning inventory and divide it by the number of units.

Is COGS an Expense?

COGS is considered an expense when it comes to running a business. You have to spend money to create an inventory, making it a necessary expense. COGS is used with other factors to determine profits. If the cost of goods is too high, your income might be low.

What Is the Difference Between Costs and Expenses?

Expenses and costs aren’t the same. An expense is a cost, but a cost doesn’t have to be an expense. Let’s take a look at an example to clarify the point.

Let’s imagine you sell souvenirs on the street. Since you have a rough estimate of how many you sell daily, you always get that amount, plus a little extra just in case. If you spent $700 on souvenirs, and you sold $500 worth of them, your costs were $700, but your expenses were $500. The remaining amount ($200) is an asset.

As you can see, expenses get used up. The remaining $200 worth of souvenirs is a cost, but not an expense. Once you sell those too, they become an expense.

Do All Businesses Calculate COGS?

All product-based businesses calculate COGS. But when it comes to service-based businesses, the difference is whether the company is only service-based or if it also sells products related to the business.

When a business has products to sell in addition to providing services, it will calculate COGS. Businesses such as plumbing, transportation, electrical, mining, etc., usually have inventory to sell. For example, a plumbing business can sell spare parts or pipes. The plumber needs to calculate his labor and the price of the part to get the COGS.

On the other hand, pure service companies don’t calculate their COGS since they don’t sell any products. Doctors, lawyers, consultants, etc., don’t have any inventory and provide only services, which is why they won’t record COGS.

How To Reduce Your COGS?

Reducing COGS as much as possible will help you increase your income. Here are a few actions you should consider to reduce your COGS:

  • Buy in large quantities. When you purchase large amounts of material or numbers of a product, you can take advantage of discounts and sales. Always check with your supplier about the possibility of getting a quantity discount.
  • Get less expensive material. Check if it’s possible to make your product by using cheaper material. However, keep in mind the quality of the end product. If less expensive material affects the product’s quality, it might not be worth it.
  • Automate your business. Depending on the type of products you’re manufacturing, you can often use machines to perform the job, thus reducing your expenses.
  • Outsource. You can move your production to a location where the labor and material costs are cheaper.

Why Is COGS Important?

Calculating and managing COGS is essential for several reasons. First of all, it’s important for your taxes. COGS is the money you spend on getting your product to your customer, which is a deductible expense. Your small business’s tax bill depends on how many items you have included in your COGS calculation. The more, the better!

Also, COGS is important for determining the success of your business. If you know your COGS, you can determine your profit and even establish your gross margin or how much money you’re making from every product you sell. The gross margin tells you whether the price of your products is too low or too high or if you’re spending too much money on production.

If you want to get the accurate cost of your inventory and the goods sold, it’s important to keep your books meticulously. Correct financial records will help you get precise and accurate numbers and allow you to find additional deductions.

Always Keep Track of Your COGS

Determining and managing the cost of goods sold can help you establish the success of your business and plan for the future. If you want to have precise information on COGS, you should ensure your bookkeeping is accurate.

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