The Cost of Goods Sold Formula: Explained

While this is a critical metric that has important implications for a company's sustainability and growth, business leaders should understand the factors that impact this value–like how much it costs them to produce the goods they sell.

As the name might suggest, the cost of goods sold formula can help measure this value, which we’ll explore in further detail below.

What is the cost of goods sold (COGS)?

The cost of goods sold, commonly referred to as COGS, is an important financial metric businesses can use to determine the cost of producing the products sold during a given period.  

This formula is only concerned with the direct costs associated with producing goods, including:

• Direct labor: Wages paid to workers directly involved in the production of goods
• Direct materials: The cost to purchase materials or inputs used to produce a company’s products
• Direct overhead: The factory lease, utilities, and other overhead costs that directly support goods production

Thus, the cost of goods sold formula does not reflect any costs the business incurs that are indirectly related to goods production, such as administrative staff salaries or office supplies, just to name a few. These costs are generally considered operating expenses, or OPEX.

Understanding the cost of goods sold formula

To find the cost of goods sold for a given period, you will use the following formula:

COGS = Starting Inventory + Purchases - Ending Inventory

In this case, starting inventory refers to any remaining products or merchandise that were left unsold in the previous period. This is the foundation for the cost of goods sold formula.

Then, you’ll add on purchases, which accounts for the value of any new inventory the company purchased or produced during the period.

The final step is to subtract any inventory that’s left at the end of the current period. The calculated value represents the cost of goods sold during the month, quarter, or year.

The value of inventory used in this formula is based on the specific accounting method the business uses, which includes first in, first out (FIFO), last in, first out (LIFO), or average cost.

The importance of cost of goods sold

Taken alone, the cost of goods sold provides useful information about how much a business spends to produce its products. Monitoring this value can help the business spot trends and seasonality of COGS throughout the year.

Plus, the total COGS will represent the business expenses you can write off on your taxes at the end of the year.

The cost of goods sold is also an integral part of a business’s income statement (sometimes called a profit and loss statement).

COGS gets subtracted from the company’s total revenue, with the leftover value reflecting the company’s gross profit.

As we mentioned earlier, COGS has a direct impact on overall profitability. All things being equal, if COGS are higher and the company spends more to produce the goods they sell, profits will take a hit.

Among other things, a business’s ability to generate profit shows that they are efficiently managing production and keeping labor and materials costs at a favorable level. Thus, business leaders often prioritize optimizing COGS and lowering costs to improve their profits.

Example of cost of goods sold formula in action

Let’s use an example of an online clothing retailer that purchases t-shirts from a wholesaler and resells them through their storefront.

They need to calculate their COGS to prepare their income statement and find their profitability for the quarter.

At the beginning of the quarter, the store had $6,000 worth of t-shirts to sell. To prepare for the summer season, they purchased an additional $4,000 worth of t-shirts to avoid stockouts. At the end of the quarter, the company had $1,500 worth of t-shirts left in inventory.

Using the cost of goods sold formula, we can see that:

COGS = $6,000 + $4,000 - $1,500

= $10,000 - $1,500

= $8,500

Thus, their cost of goods sold for the period was $8,500, which is the value that will be included on the income statement to find gross profit.

What does this tell us? The company incurred direct costs of $8,500 in order to secure the goods that they sold over the period. As long as total sales for the period were over $8,500, the company turned a profit.

Advanced application of the cost of goods sold formula

The above example is a simple application of the cost of goods sold formula, which can be used by retailers or other middlemen who purchase goods to resell them.

It was easy to determine the direct costs of this inventory, as it was simply the price at which the ecommerce store purchased the t-shirts from their wholesaler.  

However, the COGS formula can become more involved as a retailer adds more product lines.

The cost of goods sold formula is even more complex for manufacturing companies, which need to account for the direct labor, the price of the individual components that go into their product, and the overhead costs involved in the production of the goods they sell.

Final thoughts on the cost of goods sold formula

The cost of goods sold formula is one of the most common calculations used to measure a company’s financial performance.

As a key line item on the income statement, it contributes to a business’s overall profitability and is a point of interest for business leaders, shareholders, and potential investors.

While the COGS formula appears pretty straightforward on the surface, growing businesses that sell more than one product or manufacture their own goods can get frustrated with the tediousness of calculating the cost of goods sold.

Instead, if you’d prefer to have a knowledgeable team handle your finances while you focus on growing your business, contact us at Bob’s Bookkeepers.