Whether you’re taking a basic accounting course, or running a business, the cost of goods sold figure is one of the most important lines on the entire income statement. After all, Revenue – Cost of Goods Sold (also known as COGs), equals the gross profit of the business. Understanding the cost of goods in a business you run, or a business you plan on investing in, is crucial. The good news is, the cost of goods sold formula is easy to understand. Let’s dive into everything you need to know about COGs.
What is the COGs Formula
Let’s start high level and cover the cost of goods sold formula. In its simplest form, the cost of goods formula has three variables:
- The beginning or starting inventory balance
- The total purchases over a given period
- The ending inventory balance
The easiest way to understand the formula is to see it in action. Let’s apply the above variables to a specific calendar month (January).
- On January 1st, your business has $100,000 of inventory on the shelf
- Throughout January, you’re business purchases and receives $25,000 of inventory, while simultaneously selling through some of your inventory on the shelf to fulfill customer orders
- On January 31st, you have a total inventory balance of $95,000. How much inventory did you use? The answer is the cost of goods sold, which in this example is $30,000 ($100,000 starting balance + $25,000 in received purchases – $95,000)
Why are COGs Important?
COGs are critically important to a business as COGs directly impact a business’s profit margin and profit dollars. If your cost has increased, your business will be less profitable unless you pass that increased cost onto your customers. If you find a way to decrease your COGs, your business will be more profitable, and that unlocks an endless amount of opportunities.
What Goes Into the Cost of Good?
Understanding what goes into the cost of goods is a bit more nuanced. There is some grey area here, and depending on the business’s accounting method will dictate what costs truly get baked into the cost of goods formula. Here are some of the most common variables that all influence the cost of goods line item.
Raw Material Cost
Material cost greatly influences the COGs. Imagine if you are in the business of printing t-shirts. Your business buys blank t-shirts from a t-shirt manufacturer, and you were able to buy 500 blank t-shirts for $1,000, or $2 a shirt. If the price of cotton increases (which is the material your t-shirts are made out of), chances are the manufacturer will raise your price. Now instead of paying $1,000 for 500 t-shirts, you may be paying $1,200 for 500 shirts, or $2.40 each!
Shipping and Importing Cost
Another standard accounting practice is to add the cost of shipping the product to your facility into the cost of goods. For example, if those 500 shirts all fit on one pallet, and it costs $250 to ship that one pallet from the manufacturer to your facility, you could take the $250 and divide that into the 500 shirts, which would add $0.50 to your cost of goods.
Following the same t-shirt example, you’d also need to take into account the cost involved in creating the product you sell. For example, if you print a design on the t-shirts before reselling them, or if you add a patch to the sleeves, those costs would need to be added to the cost of goods. Patches, ink, logos, etc all influence how much each item costs you to produce, therefore, it influences the cost of goods sold.
What Financial Statement Shows the COGs?
If you’re looking for the cost of goods on a financial statement, jump over the income statement. The cost of a goods line item is one of the first line items on any income statement. Some companies may have the cost of goods tucked below the cost of revenue – which would be a more encompassing figure that shows the all-in cost of the revenue.
The cost of goods sold and inventory are closely tied together. However, the income statement will not show your inventory balance. If you’re looking for the starting and ending inventory balance, you’ll find that on the balance sheet.
Maximize Your Profit
If you’re looking to maximize the profit of your business, you’ll need to reduce your cost. There is not a one size fits all approach to reducing your cost, but the following examples are common practices.
Eliminate the Middle Man
Make sure you are buying from the best source at all times. Buying directly from a manufacturer, and not a reseller, will ensure you’re getting the lowest price possible. After all, if a reseller is selling you an item, keep in mind that the reseller is also making a profit!
Buy in Bulk
Many suppliers or manufacturers will offer incentives for bulk purchases. Instead of buying 500 t-shirts for $1,000, you may be able to buy 2,000 t-shirts for $3,500! That savings quickly adds up, and can quickly help you improve your product margins.
A Simple Formula, But a Powerful Outcome
The cost of goods formula is one of the first formulas you’ll learn about in an accounting class. If you’re running a business, it will also be one of the formulas you become most familiar with considering its importance on your bottom line. Understanding the nuances of this formula, and the costs that produce this number can change by industry or business. However, one thing is consistent – and that is the importance this formula has on your bottom line.
Each business may have a slight variation in what costs they include in the cost of goods sold formula. However, most businesses will include; the raw material cost, a shipping cost, and any accessory cost involved in producing the final product for sale.
The formula for calculating the cost of goods is as follows; (starting inventory balance + received purchases) – ending inventory balance.