Cost of Goods Sold Explained
When selling any type of product, the revenue from the sale is rarely, if ever, all profit.
In fact, in almost all cases, there are various expenses that the business has to take on to sell the goods in the first place, and these expenses need to be calculated to get an objective calculation of profits.
That’s where the cost of goods sold comes in.
Let’s explore what is included in cost of goods sold, is cost of goods sold an expense, why it’s important, and how you can find cost of goods sold for your business.
What is Cost of Goods Sold?
Cost of goods sold is a way to measure the expenses that a business accrues when selling products.
It allows you to figure out how much the sale of the product costs the business, so that business owners can not only better understand their profit margins and pricing structure, but also file for taxes according to how the items that make up cost of goods sold impact the bottom line.
In fact, you need to get cost of goods sold numbers precisely calculated for your business tax return, as it will reduce your business income and allow you to lower the tax bill that you’ll eventually have to pay.
The cost of goods sold can be split into two main categories:
Direct costs, which relate to either purchase or the manufacturing of the products that you are selling. Basically, it’s how much you pay the wholesaler for your products, or how much it costs for you to create them yourself.
Indirect costs of goods sold are those costs that come with warehousing, managing, and overseeing the goods sold while they are in your possession.
However, it does not include distribution or sales force costs associated with selling the product.
Still, the answer to the question – is COGS an expense – is a definite yes, and it is treated as such for tax purposes as well.
Why is It Important?
There are many reasons why a business must figure out its cost of goods sold.
Since COGS is an expense, we know that it plays a role in your business tax returns and can help lower the tax bill.
By subtracting the cost of goods sold from your gross income, you can figure out your net income and know from what amount you need to pay taxes.
But it plays a vital role in other areas as well.
For instance, as a business, you need to be able to set pricing that will allow you to maintain sustainable profit margins, which will cover all of the expenses that your business accrues.
By figuring out your cost of goods sold, you can come up with a reliable formula for establishing prices that are both competitive in the marketplace and profitable for you after you add everything up.
How to Calculate the Cost of Goods Sold?
Now that we’ve figured out what is cost of goods sold and why it matters, we need to figure out what goes into cost of goods sold and how to calculate it.
The process starts with establishing the essential components that you will need.
One way is to figure out the beginning inventory costs that you had at the start of the year, the additional costs of the inventory that you purchased throughout the year, minus the ending inventory costs that you had left at the end of the year.
The number that you will be left with is the cost of goods sold.
This number is what you can potentially deduct from your gross revenue, reducing your overall tax bill.
The next step is figuring out direct COGS vs. indirect COGS.
As we briefly discussed, direct costs include the costs of buying the products for resale or raw materials or parts for making the products. They can also include packaging costs, inventory of finished products, supplies for productions, and even overhead costs that relate to manufacturing.
Indirect costs, on the other hand, can be things like storage of products, depreciation of equipment or facilities, salaries of staff overseeing the products, administrative equipment, to name a few.
Another group of potential expenses relating to cost of goods sold is the facility expenses.
We already talked about warehousing, but in this case, you will need to allocate a percentage of your facility costs to each product sold in the period that you are calculating the COGS for.
Calculating the cost of goods sold can be a complicated process, especially in larger companies or if you are selling a range of products.
Therefore, it’s best to get help from a professional CPA who can help you work through every hurdle.
Dave Burton is a certified public accountant who can help you calculate your cost of goods and ensure that you account for every important detail. Email us at firstname.lastname@example.org and let’s figure out the best way to move forward.