The Importance of Understanding Cost of Goods Sold


Financial statements are full of valuable financial information. They often have SO much helpful information; some of it gets lost in the shuffle and missed. Make a concerted effort not to overlook your “Cost of Goods Sold” data. 

You can find this data on your company’s profit and loss statement. This critical number is how much your costs are for each item you sell and, among other things, guides you to know if your pricing is correct. Plus, it needs to be included in your tax returns each year.   

Understanding this metric can make or break your company. By having a grasp on it, your pricing becomes easier, your production more efficient, and your ability to be profitable increases. 

What is Cost of Goods Sold?


Cost of Goods Sold, also known as C.O.G.S., are the direct costs of producing the products sold by a company. This amount includes both the labor and the materials used in creating the goods. 

Do not include anything not directly related to producing a product or delivering a service, such as distribution costs, sales force costs, and any overhead.

Information to Calculate Cost of Goods Sold

To calculate the cost of goods sold, you will need to track down the following data. You can find it all in your financial documents; if not, contact your CPA.  

Direct and indirect costs:

Discovering all the COGS associated with your business allows you to deduct those costs from the products you sell, whether you manufacture them or re-sell them. Costs include labor, materials, supplies, and other associated costs.

There are two types of costs included in the Cost of Goods Sold:

Direct Costs: Costs related to the production or purchase of the product. 

Example: Labor costs are wages you pay employees who spend ALL their time working directly with your product. 

Indirect Costs: Cost related to warehousing, equipment, and labor.

Example: Labor costs are wages you pay to employees that don’t have direct connections with making your products, such as employees who stock, package, and shipment.

Determine Facilities costs

It is important to pull into your COGS the cost of your building and other locations. But this isn’t easy to determine. You must set a percentage of your facility costs (rent, mortgage, utilities, and other costs) to each product for the accounting period in question. I know it sounds like a headache. With a good accountant, it will be all worth it. 

Determine Beginning Inventory

Your beginning inventory for the year should be the same as your ending inventory of last year. Inventory includes all products in stock, raw materials, products in progress, finished products, and supplies that are part of the items you sell.

You must be meticulous and count everything in inventory or have a running count throughout the year. 

Add Purchases of Inventory Items

For most growing businesses, they are adding inventory throughout the year. You must keep track of all new inventory coming into your business. Keep packing slips and invoices for every shipment delivered to your business that affects your inventory especially raw materials. This is where a good accountant/advisor will be worth their weight in gold.

Determine Ending Inventory

Ending inventory is determined by taking a physical inventory of products and materials that remain at the end of the financial period. Ending inventory is affected by damage, worthless, or obsolete products. For damaged goods, you must report the estimated value. For worthless inventory, you must have proof that the product was destroyed. For out-of-date inventory, you must show the decrease in value.

COGS = Beginning Inventory + Purchases During the Period – Ending Inventory

The Importance of Cost of Goods Sold

Now that we have covered the basics of C.O.G.S., how to calculate them, and where to find the information, let’s dig into the why. Why do I need to understand it? Do I even have costs of goods sold in my company? 

Do I have any “cost of goods sold” for a service?

I bet a few of you are thinking, “I sell a service, not an actual product. That means I don’t have COGS.” Well, yes and no. 

For example, let’s say you are a mechanic, so most of your income is service-based. Your knowledge, experience, and time are what you are selling and what your customers want from you. The part you put in the car is not why they hired you.  But more often than not, you do provide that replacement part for your customer’s cars. These car parts are considered C.O.G.S. and should be tracked. 

Another example is a yoga instructor who occasionally sells mats, yoga props, and apparel to your clients. Even though your clients are there for your knowledge and learn from you, these items are considered and counted as cost of goods sold. 

Gross profit margin

To calculate another essential KPI, gross profit margin, you will need to know your costs of goods sold. Gross Profit Margin is a ratio used to measure a company’s financial health by revealing the amount of money left over from sales after deducting the cost of goods sold. 

Gross profit margin is calculated by subtracting the cost of goods sold (COGS) from total revenue and then dividing that number by total revenue.

As an example, let’s say our cookie company reports $1 million as their total revenue for 2018, and their COGS are $250,000. By using the above formula, we learn.

Gross Profit Margin = ($1,000,000 – $250,000)/ 1,000,000 = 75%


Make Pricing Decisions

Setting a selling price for your product is one of the hardest things in business. Too high, and no one will even take a look at what you offer. Too low, and you can’t and won’t make any profits. 

Finding that sweet spot with your pricing is best accomplished if you have an accurately calculated cost of goods sold.  Knowing your company’s COGS, you also know exactly how much you need to sell to cover your other expenses, like salaries and marketing. 

The Efficiency of your Product

As you begin to calculate and see the whole picture of your COGS, an amazing thing begins to happen. Your more granular study will help you improve the efficiency of your product production. 

Breaking down your data facilitates seeing ways to save money on each product, which adds up quickly.  Along with ways to save money, you also discover ways to make the production process faster and more efficient.

Differentiate between Direct and Indirect Costs

Understanding the Cost of Goods Sold and calculating it correctly helps you know the difference between direct and indirect costs. 

Regardless if you earn a single dollar or not, there are costs you will have to pay.  Your rent payment doesn’t change based on your monthly sales. These are your indirect costs, also called operating expenses. 

  • Rent
  • Utilities
  • Salaries
  • Marketing
  • Insurance
  • Legal and Accounting costs
  • Taxes

Having an understanding of these items and their cost sets a break-even point for your business. You are aware of your baseline costs. 

Final Thoughts

As you begin to grasp how to calculate your company’s Cost of Goods Sold, you will also start to understand the crucial role it plays in your business’s profitability. 

The bottom line is this; You must charge more for your product than it costs you to create. Otherwise, you will not be successful. You may have a spectacular product that can save your clients time and money, but you will be out of business if your pricing is incorrect. 

Let’s close with any accountant’s two favorite words… Get calculating!!!

Disclaimer: The information in this article is for your general information; it’s not tax or legal advice. Every business situation is different and tax regulations change. Please get help from your accountant/advisor to make sure your calculations are correct.

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