A retail store owner is seated at a desk in her store. She is using a calculator to determine the cost of goods sold for her shop.
It's important to know your business's cost of goods sold, for both your own benefit as the owner and the benefit of prospective investors. — Getty Images/Maskot

Cost of goods sold (COGS) is an important metric contributing to a business's overall gross profit and long-term growth prospects. This key performance indicator impacts everything from your tax rate to your pricing model and even your personal income.

A high COGS can eat into your profit and slow growth, but it is a tax-deductible expense for most businesses. Here's what you need to know about the cost of goods sold metric, including how to calculate it for your venture.

What is cost of goods sold?

COGS is the sum of all direct costs associated with selling a product or service. It includes things like materials and labor used to create the product but not indirect expenses such as distribution costs or overhead.

COGS is an important metric that is included in a business's income statement. It also impacts your taxes.

"Companies that make and sell products or buy and resell its purchases need to calculate COGS in order to write off the expense, according to the IRS," said the experts at FreshBooks. "This decreases the total amount of taxes they need to pay. Small businesses with an average gross revenue (before costs or expenses) of less than $25 million in the past three tax years report cost of goods this way."

COGS also plays a role in how you price your products. Some pricing strategies start with COGS as the baseline, or minimum, price charged to the customer. The business owner will add a percentage on top of the COGS baseline to create a profit margin and cover indirect costs. This is another reason why it's important to know your COGS.

[Read more: How to Price Your Product: A Step-by-Step Calculation]

Is COGS an expense?

Yes, COGS is an expense. COGS is deducted from total sales revenue to determine gross profit. This means that while COGS is an expense, it specifically reflects the cost of producing goods sold, impacting the gross margin of a business. It is separate from operating expenses.

COGS should only encompass direct costs related to production, like raw materials and direct labor. Unrelated expenses can inflate COGS and distort gross profit margins.

How to calculate COGS

COGS can be a little complicated to calculate. The first challenge is that the cost of making a product can change throughout the year. Inventory costs change accordingly. Therefore, there are three methods a company can use to record inventory sold over a certain time period are:

  • FIFO: first in, first out. This means the first, or earliest, goods to be purchased or manufactured are sold first.
  • LIFO: last in, first out. This means the latest goods to be purchased or manufactured are sold first.
  • Average Cost Method. The value of the goods sold is determined by the average price of all the goods in stock regardless of purchase date. "Taking the average product cost over a time period has a smoothing effect that prevents COGS from being highly impacted by extreme costs of one or more acquisitions or purchases," explained Investopedia.

The basic calculation for COGS is (Beginning inventory + Cost of goods) - Ending inventory = Cost of goods sold.

Another option is to use change in inventory. For instance, if 200 units are made or bought but inventory rises by 50 units, then the cost of 150 units is the cost of goods sold. If inventory decreases by 50 units, the cost of 250 units is the cost of goods sold.

Key mistakes to avoid in calculating the cost of goods sold

Often, business owners add in the wrong costs when calculating COGS. One of the most prevalent errors is including indirect costs, such as administrative expenses or marketing costs. COGS should only encompass direct costs related to production, like raw materials and direct labor. Unrelated expenses can inflate COGS and distort gross profit margins.

Inventory is another element that contributes to errors in COGS calculations. Failing to accurately track beginning and ending inventory can lead to an incorrect result. Regularly perform physical inventory checks to make sure you reflect actual counts and valuations at the start and end of the accounting period. Write off obsolete inventory and be consistent in the method you use (FIFO, LIFO, etc.) to ensure get an accurate COGS.

Finally, raw material costs can fluctuate over time, depending on your industry. Update your COGS calculation to reflect these fluctuations and avoid using outdated financial data. Regularly review and adjust your COGS based on current market conditions.

Accounting for the cost of goods sold accurately

Perhaps the most difficult part is understanding which direct and indirect costs apply to your COGS. Most costs included in your calculation will be direct costs, but in some cases, you may be able to include a portion of your indirect costs.

For instance, indirect costs such as overhead costs at the manufacturing site, distribution costs, or supplies used to make or sell the product can sometimes be factored into your COGS. Direct labor can also be included as long as you have the documentation to support your claim.

If you're still unsure how to calculate COGS, try this free online COGS calculator and speak to a tax professional who can help.

[Read more: Amid Supply Chain Disruptions and Demand Shifts, Brands Rethink Pricing Strategies]

CO— aims to bring you inspiration from leading respected experts. However, before making any business decision, you should consult a professional who can advise you based on your individual situation.

CO—is committed to helping you start, run and grow your small business. Learn more about the benefits of small business membership in the U.S. Chamber of Commerce, here.

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