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.
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.
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:
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:
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.
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.
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.
Reducing COGS as much as possible will help you increase your income. Here are a few actions you should consider to reduce your COGS:
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.
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.
As a small business owner, you have a lot of things on your plate. To make your life as an entrepreneur easier, try Swyft Books. We connect you to professionals who can help you with all areas of running your business, including managing COGS. Get your free trial, and run your business without worrying about bookkeeping.