Understanding COGS isn’t just about accounting—it’s about making smart decisions for profitability, pricing, and more.
This blog walks you through everything you need to know about COGS, from defining the term to showing you how to calculate it and leverage it for your business growth.
1. What is Cost of Goods Sold (COGS)?
COGS represents the direct costs involved in creating the products your business sells. These include things like materials, labour hours, and the manufacturing overheads. Essentially, any expense that contributes directly to creating the end product is cost of goods sold - COGS
COGS provides critical insights into your business’s efficiency and profitability. It’s a fundamental metric that shows how much you’re spending to produce inventory relative to your sales. And in turn how much profit you are making..............
Example
If you run a trade business, the cost of timber, purlins, steel, electrical, plumbing, windows, wages are all are part of your COGS. However, your yard rent, power, website maintenance, bookkeeping costs do not—those are your overhead operational expenses.
2. What are the components of COGS?
It includes different types of costs depending on your business.
Here are the main components typically included in COGS:
Materials: Raw ingredients or parts used to create your product (e.g., fabric for making clothes or ingredients for prepared meals, or materials that go into building or renovating the house).
Wages:The wages you pay to employees directly involved in production (e.g., sewing a shirt, baking a cake, building the house as well as any subbies).
Manufacturing Overheads: Indirect costs required to produce goods, such as equipment depreciation or utility costs used in production.
3. How do I calculate COGS?
Whew, fortunately however, calculating COGS follows a straightforward formula:
COGS = Beginning inventory + Purchases during the period – Ending inventory
Breaking it down:
Beginning inventory: The value of inventory on hand at the start of the accounting period.
Purchases: All costs for new inventory bought or manufactured during the period.
Ending inventory: The value of unsold inventory at the period’s end.
Example Calculation
Your beginning inventory is $15,000,
You spent $28,000 on materials and production, and
Your ending inventory is $32,000,
Then your COGS would be:
$15,000 + $28,000 – $32,000 = $11,000
This $11,000 represents the cost of creating the products you sold during the period.
4. What are the various COGS accounting methods?
How you calculate and report COGS can depend on the accounting method you choose for inventory valuation. Here are the most common methods and great for manufacturing businesses:
First-in, First-out (FIFO): Oldest inventory is sold first. This is great when prices rise as the lower-cost items are accounted for first, lowering COGS.
Last-in, First-out (LIFO): Newest inventory is sold first. When prices rise, LIFO increases COGS but reduces taxable income.
Weighted average cost (WAC): Assigns an average cost to all inventory. Simple and ideal for businesses with indistinguishable inventory items.
Pro Tip
Consult with your advisor to identify the best method for your business—tax implications vary by approach.
5. Why does understanding COGS matter?
Knowing your COGS is a game-changer for managing and growing your business. Here are some ways it benefits you:
Profitability analysis
COGS is crucial for calculating your gross profit. Subtracting COGS from your revenue reveals how much your products are contributing to your bottom line.
Pricing strategy
Understanding how much each product costs to make allows you to set prices that cover expenses while leaving room for profit.
Inventory management
COGS helps track costs related to unused or unsold inventory, ensuring you’re not overstocking items that don’t sell.
Financial reporting
COGS is a must for accurate income statements and tax reporting. It demonstrates operational efficiency—which is key for attracting investors or securing loans.
Tax benefits
COGS is deductible for tax purposes, reducing your taxable income. The more precise your calculations, the better-positioned you’ll be.
6. How your advisor can help
Understanding your Cost of Goods Sold isn’t just an accounting exercise—it’s the foundation for business success. By calculating and tracking COGS effectively, you’ll empower yourself to make better decisions about pricing, profitability, and growth.
If you’d like help navigating COGS or developing your financial strategy, reach out to us today.
