Cost of Goods Sold

Cost of Goods Sold

Your cost of goods sold (COGS), or cost of sales, are the costs directly related to purchasing products for resale, manufacturing products to sell, or providing services.

Your COGS are documented on your income statement and are used to calculate your gross profit margin.

Cost of goods sold can be deducted from your business’s income as a business expense, which will reduce your tax liability.

What are Direct Costs?

The actual direct costs of your goods will vary from business to business, but they can include:

  • the cost to purchase merchandise for resale,
  • the cost of raw materials,
  • packaging costs,
  • the cost of inventory of finished products,
  • supplies for production, and
  • direct labor.

How to Calculate COGS

To calculate your COGS, subtract your ending inventory from your beginning inventory and total purchases made.

COGS = Beginning Inventory + Purchases Made – Ending Inventory

If you begin the period with $5,000 in inventory, purchase $2,000 in materials during the period, and end the period with $3,000 in inventory, your COGS are $4,000.

COGS = $5,000 + $2,000 – $3,000 = $4,000

What if My Costs Change during the Year?

If your direct costs change during the year, there are several methods to calculate your cost of goods sold:

  • First In, First Out (FIFO),
  • Last In, Last Out (LIFO), or
  • Average Cost.

Example

You bought products for resale in three batches during the year and sold 400.

  1. 100 products at $10 each = $1,000
  2. 250 products at $10.50 each = $2,625
  3. 150 products at $11 each = $1,650

FIFO

Using the FIFO method, you assume that the first products purchased were the first products sold. You sold 100 products at $10 each, 250 products at $10.50 each, and 50 products at $11 each.

COGS = (100*$10) + (250*$10.50) + (50*$11) = $4,175

LIFO

Using the LIFO method, you assume that the last products purchased were the first products sold. You sold 150 products at $11 each and 250 products at $10.50 each.

COGS = (150*$11) + (250*$10.50) = $4,275

The IRS doesn’t like the LIFO method, but you can apply to use it by filing Form 970.

Average Cost

The average cost method uses the average cost of each product.

Average Cost = ((100*$10) + (250*$10.50) + (150*$11))/500 = $10.55

COGS = 400*$10.55 = $4,220