Retailers want to track cost of goods sold (COGS) to ensure they are profitable and reporting expenses to the IRS correctly. Show
Considering 21% of small business owners feel they don’t have enough knowledge about their accounting and finance, it’s a good idea to understand how COGS can impact your accounting and sales. This guide will walk you through what’s included in COGS, how to calculate it, and different methods to help prepare for tax season. Table of Contents
What is cost of goods sold (COGS report)?Cost of goods sold (COGS) is the direct cost of producing products sold by your business. Also referred to as “cost of sales,” or "COGS report," COGS includes the cost of materials and labor directly related to the production and manufacturing of retail products. COGS excludes indirect costs, such as distribution and marketing costs. A product requires materials and parts, but it also requires a number of other things:
Not to mention the overhead: the labor, rent, equipment, electricity to run the operations, and employees to sell said products in your store, as well as sales, marketing, finance, and all the other departments. That’s a lot. And that’s what it costs to sell things. As a result, these are all expenses that contribute to the end cost of the product. Expenses you need to keep track of to ensure you are making not only a healthy gross profit but that you can accurately price products and keep healthy margins. Stay on top of your finances With Shopify POS, it’s easy to create reports and review your finances including sales, returns, taxes, payments, and more. View your financial data for all sales channels from the same easy-to-understand back office. Importance of COGSCOGS is subtracted from sales to calculate gross margin and gross profit. The higher your COGS, the lower your margins. As a retailer, you need to keep a close eye on cash flow or you won’t last very long. But there are many other factors to keep track of COGS as well as other line items. The biggest factor is the Internal Revenue Services (IRS). Sure enough, when reporting taxes, Uncle Sam (or your localized government equivalent) wants to know how much a business made so it can tax said business accordingly. The good news is that COGS are small business expenses—which means they don’t count toward your gross revenue. And COGS is an expense line item in your company’s income statement, otherwise known as a profit and loss statement, or P&L. The IRS allows you to deduct the cost of goods that are used to make or purchase the goods you sell in your business. By calculating all business expenses, including COGS, it ensures the company is offsetting them against total revenue come tax season. This means the company will only pay taxes on net income, thereby decreasing the total amount of taxes owed when it comes time to pay taxes. A note on COGS and taxes: While high COGS means lower taxes, that is not the ideal scenario, because it ultimately also means lower profitability for the company. It’s important to manage COGS efficiently in order to increase profits. What’s included in cost of goods sold?
The cost of goods sold is essentially the wholesale price of each item, which includes the direct labor costs required to produce each product. Materials
Labor
Operations
Exclusions from cost of goods soldNot all companies can list COGS on their income statement. Service companies don’t have a COGS, and cost of goods sold isn’t addressed in generally accepted accounting principles (GAAP). It’s only defined as the cost of inventory items sold during an accounting period. COGS vs. operating expensesOperating expenses and cost of goods sold are two different expenses that occur in your daily business operations. They are both subtracted from your business’ total sales figures. Yet they are recorded as separate line items on your income statement. Operating expenses refer to expenditures not directly related to the production of your products. These include:
A business must budget for operating expenses while keeping its competitive edge. You incur these costs regardless of how many sales you make. For example, a fashion boutique must pay rent, utilities, and marketing costs no matter how many items it sells in a month. When the boutique sells a shirt, COGS accounts for the sewing, the thread, the hanger, the tags, the packaging, and so on. It also includes any goods bought from suppliers and manufacturers. Information needed for cost of goods sold calculationTypically, the CFO or other certified accounting professional would handle these calculations because it’s not as simple as we’ve laid out in the example above. However, for the DIY CEO, calculating COGS requires a bit of information prep beforehand in order to report accurately. Here’s what you need to calculate COGS.
How to calculate cost of goods soldHere’s what a common COGS formula looks like: (Beginning Inventory + Purchases) – Ending Inventory = COGS Now let’s look more closely at how to calculate COGS. Determine direct vs. indirect costsWhen doing the math, it’s important to remember there are two types of costs associated with each product: direct and indirect costs. Direct costs are all costs directly associated with the product itself. This includes:
Indirect costs include:
A note on facilities costs: This part is tricky and requires an experienced accountant to accurately assign each product. These costs need to be divided strategically among all the products being manufactured and warehoused, and are usually calculated on an annual basis. Determine beginning inventory and cost of purchasesWhether you sell jam, t-shirts, or digital downloads, you’ll need to know how much inventory you start the year with to calculate cost of goods sold. It’s important to keep track of all your inventory at the start and end of each year. Your inventory doesn’t simply include the finished products in stock and ready for resale, but also all the raw materials you have, any items that have been started but not completed, and other supplies. For accounting and reporting purposes, it’s imperative that both your beginning inventory and your ending inventory (from the previous fiscal year) match up exactly—otherwise, a detailed explanation needs to be included. Further, whatever items and inventory are purchased throughout the year that don’t fall under the beginning or ending inventory must be accounted for as well. These are the cost of purchases and include all items, shipments, manufacturing, etc. As with your personal taxes, you need to keep all paperwork to show these items were purchased during the correct fiscal year. Determine ending inventoryAt the end of the year, it’s important to take stock of all the inventory that remains. This means all products that remain and have not been sold. As we’ve discussed, this information will be used in the current COGS calculation, but will also be required for the following year’s calculations as well. All inventory can be categorized as resale ready, damaged (requires the estimated value of the items damaged), worthless products (evidence of destruction must be provided), and obsolete items (evidence of devaluation needed). For the latter, these products can be donated to charities for a little extra goodwill. Accounting methods for COGSThe value of COGS depends on the costing method chosen by a business. Here are four different accounting methods you could use to value inventory:
Weighted average costInventory weighted average, or weighted average cost, is one of the four most common inventory valuation methods. It uses a weighted average to figure out the amount of money that goes into COGS and inventory. In this method, the average price of all products in stock is used to value the goods sold, regardless of purchase date. It’s an ideal method for mass-produced items, such as water bottles or nails. Take the following inventory buys for example:
Your total inventory would be $2,425. Your average cost per unit would be the total inventory ($2,425) divided by the total number of units (450). That’s $5.39 per unit. To find the weighted average cost COGS, multiple the units sold by the average cost. If you sell 100 units, your weighted average cost would be $539. First in, first out (FIFO)First in, first out, also known as FIFO, is an assessment management method where assets produced or purchased first are sold first. This method is best for perishables and products with a short shelf life. For example, say you bought units X, Y, Z and got two orders for one unit each. Using FIFO, your first order is $5 because you bought unit X first. Assuming the first order depletes unit X, the COGS on your second order is $6 because that’s the next unit you bought. When prices are rising, the goods with higher costs are sold first and the closing inventory will be higher. This results in higher net income over time. When prices are decreasing, the opposite is true. Last in, first out (LIFO)LIFO is the opposite of FIFO. It assumes the goods you purchased or produced last are the first items you sold. When prices are rising, goods with higher costs are sold first and closing inventory is lower. This results in a decreasing net income. Using the example above, your LIFO COGS for the first order would be $5.50 because you bought unit Z last. The COGS on your second order is $6 because the next unit you bought was Y. During times of inflation, LIFO leads to a higher reported COGS on your financial statements and lower taxable income. Special identification methodThe special identification method tracks the specific cost of each unit of goods to determine ending COGS and inventory for each accounting period. A business knows exactly which items were sold and the exact cost. For example, if unit Z costs you $7.50 and you sell it, the COGS would be $7.50. This method is used for selling unique items such as rare jewels, cars, real estate, and other luxury items. Cost of goods sold exampleLet’s say your company has the following information for recording the inventory for the calendar year ending on December 31, 2022. Your inventory at the beginning of the year, recorded on January 1, 2022, is $20,000. At the end of the year, on December 31, 2022, your ending inventory is $6,000. During the year, your company made $8,000 worth of purchases. Let’s calculate COGS using the formula above: (Beginning Inventory + Purchase) - Ending Inventory. COGS = ($20,000 + $8,000) - $6,000 COGS = $22,000 Having this information lets you calculate the trust cost of goods sold in the calendar year. COGS helps you evaluate the cost and profits but also helps plan out purchases for the next year. 💡 PRO TIP: Shopify makes it easy to find your cost of goods sold at the end of your calendar year—no manual calculations or formulas required. To get started, go to the Finances summary report from your Shopify Admin and select the time period you want the report to reflect. Using COGS for your retail storeWhether you’re opening your first retail store or your fifth, the accounting process is tough. Business owners can’t control the price of each other’s suppliers. But what you can control is the accounting methods you use to track metrics like COGS. Be thorough in your accounting practices. Partnering with a good accountant can change your small business for the better. Not just by taking the headache out of tax preparation, but by providing financial advice that improves your bottom line. Try Shopify POS for omnichannel selling Bring your in-store and online sales together with Shopify POS. Gain insights about your business from one view so you can work smarter, move faster, and think bigger. COGS FAQHow do you calculate the COGS?Cost of goods sold (COGS) is calculated by using the COGS formula, which is represented as: (Beginning Inventory + Purchases) – Ending Inventory = COGS. Does labor go into COGS?Yes, labor is included in cost of goods sold. This includes the parts and supplies required to create the product as well as the people who assemble or build the product. Are COGS an expense?Yes, since cost of goods sold is deemed to be a cost of doing business, COGS is recorded on income statements as an expense. What are examples of cost of sales?Some examples of cost of sales or COGS include, manufacturing parts, shipping costs, and labor associated with building or assembling products. What overhead is included in COGS?The overhead that is included in COGS is any overhead related to labor, materials, and operations that are directly tied to producing a product or service. How to calculate costs of goods sold formula?At a basic level, the cost of goods sold formula is: Starting inventory + purchases − ending inventory = cost of goods sold.
How to calculate the cost of goods sold for the year?Cost of goods sold (COGS) is calculated by taking the value of inventory at the beginning of the period being studied, adding the cost of any new inventory purchased over the covered period, and subtracting the value of inventory held at the end of the period.
How to calculate cost of goods sold in trial balance?The cost of goods sold is how much a business's products cost to buy or produce. A simple formula to calculate the cost of goods sold is to start with your beginning inventory value, add any purchases or other costs, and subtract your ending inventory value.
Which of the following is correct to calculate cost of goods manufactured?The formula to calculate COGM = Beginning WIP inventory + total manufacturing cost - ending WIP inventory.
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