How to Calculate Cost of Goods Sold

This is multiplied by the actual number of goods sold to find the cost of goods sold. However, due to rising material prices, the last unit costs $10 to produce. For example, assume that a company purchased materials to produce four units of their goods. It helps management and investors monitor the performance of the business.

It means roughly 80% of your revenue comes from 20% of your products. Your product cost, inbound shipping, duties, and direct production labor. COGS is the total direct cost of producing or buying the products you sell. At tax time, you’ve understated costs and overstated income. Use accrual accounting to match COGS to the period you earn the revenue.

LIFO (Last-In, First-Out)

The higher your production costs, the higher you need to price your product or service to turn a profit. Again, you can use your cost of goods sold to find your business’s gross profit. Gross profit is the revenue left over after you deduct the costs of making a product or providing a service. Operating expenses, or OPEX, are costs companies incur what is an audit during normal business operations to keep the company up and running. Again, COGS only includes the production costs. When calculating cost of the goods sold, do not include the cost of creating products or services that you don’t sell.

IFRS and US GAAP allow different policies for accounting for inventory and cost of goods sold.
It aligns accounting precision with business strategy, ensures compliance with international accounting standards, and provides the foundation for evaluating profitability.
That’s why COGS is often the subject of fraudulent accounting.
Depreciation and amortization (D&A) depend on the historical investments the company has made and not on the current operating performance of the business.
This type of COGS accounting may apply to car manufacturers, real estate developers, and others.
They would use the standard retail model to track the inventory and costs for those physical items.
Different accounting treatments can also yield different results of running the cost of goods sold formula.

If your business is brand new, your beginning inventory is $0. What remains is the direct cost of the specific items you sold during that time. It’s all about tracking the flow of your inventory over a set period, whether that's a month, a quarter, or a full year. At first glance, accounting formulas can look a little scary.

Since depreciation and amortization are non-cash expenses, both are added back to net income on the cash flow statement (the expense on the cash flow statement is usually a positive number for this reason). Because of this, analysts may find that operating income is different than what they think the number should be, and therefore, D&A is added back to EBIT to calculate EBITDA. Depreciation and amortization (D&A) depend on the historical investments the company has made and not on the current operating performance of the business. Interest expense comes from the money a company has borrowed to fund its business activities. Critics — such as Warren Buffett — caution against relying too heavily on EBITDA because it ignores critical costs like depreciation, which reflect the true wear and tear on a company’s assets.

On the income statement, COGS is deducted from revenue to determine gross profit. Service businesses typically use “Cost of Revenue” rather than COGS, but companies offering both products and services need careful categorization. Inbound shipping costs (freight-in) should be included in COGS as they’re directly attributable to acquiring inventory. Many businesses incorrectly include administrative salaries, marketing costs, or general overhead in COGS calculations. For Ecommerce businesses, understanding what qualifies as direct costs is essential for accurate COGS cost of goods calculation.

What COGS includes (and excludes)

The key takeaway is that if a cost isn't directly tied to producing or acquiring a specific product you sold, it probably doesn't belong in COGS. This number is a major player on your income statement because it gets right to the heart of your business's profitability. It covers things like raw materials and the labor needed to make the product, but it leaves out indirect expenses like your marketing budget or office rent. This is because it's hard for external parties, like investors or tax authorities, to check inventories and direct costs. COGS helps indicate how well a company is generating profit from its core business.

In theory, COGS should include the cost of all inventory that was sold during the accounting period. Importantly, COGS is based only on the costs that are directly utilized in producing that revenue, such as the company’s inventory or labor costs that can be attributed to specific sales. By contrast, COS includes not only the direct costs of goods sold but also other costs directly related to generating revenue, such as direct labor and direct overhead. At the end of the year, the products that were not sold are subtracted from the sum of beginning inventory and additional purchases. Any additional productions or purchases made by a manufacturing or retail company are added to the beginning inventory.

That's where Rho fits in.Rho integrates with platforms like Quick Books, Net Suite, Sage Intacct, and Microsoft Dynamics 365—so your financial data flows seamlessly across systems. Examples of leading automation platforms that can do this include Quick Books Online, Net Suite, Sage Intacct, and Microsoft Dynamics 365. But when those systems don't talk to each other—or when things are tracked in spreadsheets—it's easy for mistakes to happen or for costs to get misclassified.That's where automation makes a real difference. They rely on data from inventory systems, procurement tools, and time tracking to piece together the full picture. If you've ever pulled together a COGS calculation manually, you know it can be a messy process—especially as your business grows.

Small business survival toolkit

Mastering the cost of goods sold formula is a journey that transforms your business's financial clarity. Finale's weighted-average costing engine automatically recalculates the cost of goods sold formula after every transaction affecting inventory value. For a broader understanding of how these technologies work together, explore our guide to accounting and inventory software options for businesses at every growth stage. For growing businesses, consider upgrading to specialized inventory and accounting software for small business that automates these calculations.

Do I Really Have to Do a Physical Inventory Count Every Year?

Accurate COGS calculation is therefore crucial for pricing decisions, product mix strategy, and financial planning. This method is especially valuable for multichannel sellers tracking inventory across multiple locations with different acquisition costs. This method recalculates the average unit cost after each new purchase by dividing total inventory cost by total units. LIFO often results in higher COGS and lower taxable income during inflation. LIFO (Last-In, First-Out) assumes newest inventory sells first, resulting in COGS that reflects current costs.

However, they may also include travel costs and any sales commissions, etc. Service companies' main costs are usually direct labor, such as the cost of a consultant's time when working on a project. Companies that sell services use either the cost of revenue or the cost of sales to account for the expenses incurred while creating their offering. It's hard to check inventory numbers, for example, and a lower COGS can inflate profits. In reporting a lower COGS, the company's profits will be inflated and its performance will look better than it actually is.

We then add any new inventory that was purchased during the period.
After calculating beginning inventory, ending inventory, and inventory-related purchases, you can find the Cost of Goods Sold using the formula shown at the beginning of this article.
However, due to rising material prices, the last unit costs $10 to produce.
Finale Inventory tackles these challenges head-on with purpose-built solutions for e-commerce businesses.
Along with teaching at business and professional schools for over 35 years, she has author several business books and owned her own startup-focused company.

Companies that sell a service, rather than a good, often use the cost of sales or cost of revenue instead. The cost of goods sold is one of the biggest expense items for most companies. Take your learning and productivity to the next level with our Premium Templates.

Inaccurate inventory counts lead to distorted COGS calculations and poor business decisions. This method calculates a weighted average cost for all inventory items, smoothing out price fluctuations. LIFO assumes the newest inventory is sold first. FIFO assumes the oldest inventory items are sold first. This should include the cost of purchases as well as any freight and handling charges, while subtracting purchase returns or allowances. The difference represents what was actually sold during the period.

To calculate COGS, you must take into consideration all expenses directly involved in the manufacture and production of your goods, as well as some overhead expenses. COGS refers to the direct costs of goods manufactured or purchased by a business and sold to consumers or other businesses. You'll typically find the cost of goods sold on the line directly underneath total revenue when looking at a company's income statement.

Reducing COGS through better supplier negotiations, efficient production, or reduced waste immediately improves gross margin. The weighted average inventory method calculates COGS based on the average cost of all similar inventory items available during the period. While FIFO better represents physical inventory flow, LIFO may better match current revenue with current costs.

In manufacturing firms, analysts often compare COGS-to-sales ratios to evaluate production effectiveness and procurement discipline. Automation, robotics, and digital inventory management systems can reduce waste, labor costs, and inefficiencies, leading to a lower COGS ratio over time. In service industries such as software development, COGS might include server hosting or software licenses directly tied to service delivery. This example illustrates that any costs necessary to make the goods ready for sale—including inbound shipping and warehousing—should be included in COGS. The closing inventory includes unfinished goods and raw materials not yet used. The closing inventory of $12,000 will appear as a current asset in the balance sheet, ready for sale in the next period.

For a logistics company, COGS would include warehouse staff wages and the boxes used for shipments, but not the CEO’s salary. For a restaurant, COGS would include food costs, but not Instagram ads. On your income statement, COGS sits just below revenue.

A lower COGS leads to a higher gross profit, improving the company’s ability to cover operating expenses and achieve net profitability. In this case, the total COGS captures all materials and direct labor involved in producing the candles that were sold within the accounting period. For manufacturers, this includes production costs, while for retailers, it mainly covers purchase costs and handling.

Once your methods are chosen and your inventory values and purchases are totaled, it’s time to perform the COGS calculation. It usually results in a higher COGS and a lower closing inventory value, which can result in lower taxes. Be aware that your chosen method will directly affect your balance sheet, cash flow statement, and other key financials. In more complicated situations, you may choose to use FIFO or LIFO methods to calculate inventory value, as explained below. If the actual cost of each item in your inventory is known, you may simply add up the costs to determine the value of your inventory.