Every business has a product or service to sell. No matter what it is that you're selling—or how much you're selling—you're going to want to get a handle of the cost of goods sold of your product or service if you want your business to be profitable.
Cost of goods sold, sometimes abbreviated as COGS or called "cost of sales," is the direct cost of producing the product or service offered by your business. What do we mean by direct costs? Direct costs are limited to those costs that relate directly and obviously to the production of your product and service. This translates to the raw materials and direct labour used to bring the product or service into existence. Without these things, you wouldn't have a product or service to sell in the first place!
Let's say your company sells a clothing item, like custom hoodies. Your direct costs in this case would be the cost of raw materials: fabric, thread, the sewing machines used to make the hoodies, and even the electricity used to power the sewing machines. It also includes the direct labour costs: the money you pay to the people who do the actual working of manufacturing the hoodies.
There are, of course, various other costs associated with your product or service that don't directly impact the creation of the product or service like direct costs do: these are referred to as indirect costs, and would include expenses like the cost of distributing your product or service, marketing and advertising, and wages paid to your sales team.
How Do I Calculate and Record Cost of Goods Sold?
The basic way to calculate the cost of goods sold for a given period is to take the value of your inventory at the beginning of that period, add the total amount of purchases related to inventory made during the same period, and then subtract the value of the inventory left at the end of the period.
The equation looks something like this: Beginning Inventory + Inventory Purchases - End Inventory = Cost of Goods Sold.
You will find cost of goods sold on your company's income statement under your expenses. Want to learn more about expenses and how they're recorded? Check out our recent blog post, What is an Expense in Accounting?
Why is Cost of Goods Sold Important?
The main reason you'll want to keep an eye on cost of goods sold is that it is linked in an important way to your company's profit. It goes without saying that profit is important to growing your business and assessing your company's overall financial health—and the cost of goods sold is a piece of that profit picture.
One way it's related is in the calculation of your company's gross profit margin. You can subtract your cost of goods sold from your company's revenue to get your gross margin, which is a key way to evaluate how much you're making from sales and how efficient your business is being run. (Read more about profit margin.)
You can think of cost of goods sold as one more way in which you can analyze whether or not your company is in good financial health. Part of this is figuring out whether or not the pricing of your product or service makes sense (i.e. whether it allows you to generate a decent profit). Once you get an accurate measure of the cost of goods sold for a particular product or service, you will know the expenses that will be associated with every single sale you make, and whether or not that sale will be profitable.
Want to know if you're using profitable pricing? Compare the price of your product or service with the associated cost of goods. Is the price lower than the cost of goods sold? If so, you're in trouble, because you're going to lose money every single time you make a sale. And that's not the reason you started your business, is it?
There should be money left over when you deduct the cost of goods sold from your pricing. But remember: cost of goods sold only includes the direct cost of producing your product or service. All of your indirect costs (overhead, indirect labour, etc.) have to be covered and then some if you're actually going to generate a profit. Cost of goods sold is therefore a great way to test whether or not your pricing model is realistic, and to get an idea of what kind of sales volume you'll need to generate and maintain to grow and stay in business. If you find that your profit margins are relatively low, you'll either need to increase your pricing, boost your sales volume, or figure out a way to cut expenses in order to be profitable and grow your business.
Now that you know the basics about cost of goods sold, you have another tool at your disposal to create an accurate picture of your company's financial health. As always, if you have any questions, you can get in touch with us at email@example.com. We'd love to hear from you!