Any business that sells products needs to know its cost of goods sold.

Why? Put simply, it’s one of the biggest indicators of revenue, profit, and business sustainability.

In this blog post, we’ll dive more into what cost of goods sold is and why it matters, go over the cost of goods sold formula, and give you a few tips for optimizing cost of goods sold in your business.

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What is Cost of Goods Sold?

Cost of goods sold, or COGS, is a business and sales metric that determines the value of inventory sold (and created, if you’re the manufacturer) in a specific time period. The formula looks at all costs directly traceable to whatever it is you are selling, which is the product and -- if you are the manufacturer -- the direct labor put into producing the good.

The formula for calculating cost of goods is:

Cost of Goods Sold = Beginning Inventory + Purchased Inventory - Ending Inventory

You can easily calculate cost of goods sold with our free business metrics calculator.

Because COGS tells business owners how much it costs to acquire what’s to be sold, the number ties directly back to profit and revenue. For example, if your COGS is the same as or lower than your revenue for that time period, it means you’ve broken even or have lost money and are not profitable.

To ensure clarity, businesses should look at their COGS for a specific time period (a day, a quarter, a year, etc.) and compare it to a different time period of the same length to see how sales changed.

A common disclaimer is that COGS is best when it’s low. This is true in part. After all, if your cost of goods sold is zero, that either means you’ve acquired your inventory for no cost whatsoever or you sold nothing.

If it’s the latter, you’ve earned no profit. What you want to do is reduce COGS by lowering how much you spend on your inventory. We’ll highlight a few tips for that later on in the post.

Cost of Goods Sold Formula

Calculating cost of goods sold varies based on if you are the manufacturer or the middleman. We’ll go through both to make things clear.

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Cost of Goods Sold Formula for Manufacturers

Product manufacturers have a more complex approach to calculating COGS because of all the components in their inventory.

For example, if you’re manufacturing backpacks, think of everything that goes into making one. The metal for zippers, the cloth, the plastic for securing the straps, and even the labor hours directly traceable to production (like hourly wages for warehouse workers) all play a role in the backpack’s production cost.

In that example, calculating cost of goods sold for your backpacks is first done by calculating the total amount of inventory in your possession at the start of the time frame.

Let’s say it’s a one-month period and on the first day of the month the company has a beginning inventory of backpacks that cost $1,000,000 to manufacture from material and labor.

Throughout the time period, the company produces an additional batch of backpack making materials at a cost of $700,000, broken down as follows:

  • $400,000 on the cloth for the backpacks.
  • $200,000 on metal for zippers.
  • $50,000 on the plastic for securing the straps.
  • $50,000 on the hourly wages of the warehouse workers responsible for producing the products.

At the end of the month, the company has a remaining inventory of backpacks that cost $500,000 to make.

So, let’s identify the variables in this situation:

  • Beginning Inventory = $1,000,000
  • Purchased Inventory = $700,000
  • Ending Inventory = $500,000
  • Beginning Inventory = $10,000
  • Purchased Inventory = $20,000
  • Ending Inventory = $2,000

Now, plug them into the cost of goods sold formula:

  • Cost of Goods Sold = Beginning Inventory + Purchased Inventory - Ending Inventory
  • Cost of Goods Sold = $1,000,000 + $700,000 - $500,000
  • Cost of Goods Sold = $1,200,000

This means the manufacturer’s total number of backpacks sold during this month cost $1,200,000 to produce.

Cost of Goods Sold Formula for Middlemen

Luckily for middlemen and redistributors, COGS is much more simple to determine. Here, you’ll just have to look into inventory, since your employees’ hourly labor is not tied to the production of these goods.

Let’s continue with the backpack example for a school supply store. Say they had $10,000 worth of backpacks at the start of the month, but it’s the last month of summer vacation, and so the store stocks up on an additional $20,000 worth of backpacks. At the end of the month, they have just $2,000 worth of backpacks to be sold to their customers.

The variables are:

  • Beginning Inventory = $10,000
  • Purchased Inventory = $20,000
  • Ending Inventory = $2,000

Time to crunch some numbers!

  • Cost of Goods Sold = Beginning Inventory + Purchased Inventory - Ending Inventory
  • Cost of Goods Sold = $10,000 + $20,000 - $2,000
  • Cost of Goods Sold = $28,000

This means that the total amount directly traceable to the backpacks the store had to spend was $28,000.

Where COGS can get layered for retail stores and distributors is with different product lines. Businesses like grocery stores and hardware stores have thousands of different products on their shelves, so tracing what specifically caused COGS to go up or down can be difficult. In the section below, we’ll highlight the ways you can address this issue in your company.

Cost of Goods Sold Best Practices

Since cost of goods sold is so crucial to your business, taking efforts to optimize it can pay off in many ways. Here are a few of our recommendations for controlling your cost of goods sold.

1. Work Out Deals With Suppliers

Oftentimes, suppliers are willing to negotiate on the price of what they sell you if you can buy in bulk, commit to an exclusive agreement, or sign onto a long-term partnership. If you’re able to do this, you can lower the cost of this inventory and keep the price to your customers the same, resulting in more profit for you and no difference in quality for customers.

This process and type of partnership takes a while to find the right vendors and build a level of trust, but if successful, can be a huge money generator for your business.

2. Organize COGS by Category

While looking at COGS over time provides clear projections of growth and sustainability of the business, it doesn’t provide the opportunity to get granular. One option is to look at COGS for a specific product or product category to measure sales more specifically.

This path will definitely take organization. You’ll need to develop a system for classification and organization that works for your reports. But it provides clear insight into how certain goods contribute to your bottom line.

3. Look Into Automation

One way for manufacturers to lower their cost of goods sold is to consider automation. Investing in machines that do the job in place of human workers usually requires a hefty upfront payment, but in the long run, your cost of goods sold could be lowered.

Obviously, automation is a hot-button issue in today’s economy and has a bad rep for displacing certain workers. Take the time to run not only a cost analysis but also an analysis on how this could impact the image of your business as a whole.

4. Reduce Waste and Theft

Waste and theft can create an enormous variance between the inventory you purchase and the inventory you sell. Prioritize efficiency and oversee staff to ensure every piece of inventory goes into the final product and every final product goes to a customer. This will go a long way in controlling your cost of goods sold.

Calculating cost of goods sold can be confusing, but it’s an essential step in measuring the health and growth of your business. Get started today and see how it benefits your company.

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Originally published Aug 7, 2019 7:30:00 AM, updated August 14 2019

Topics:

Sales Metrics