Understanding Cost of Goods Sold and How to Calculate It

When running a business, it is essential to determine the Cost of Goods Sold (COGS), a crucial component that must be included in your business’s financial statements to assess whether it is making a profit or not.

As such, it is essential to understand the definition of COGS and how to calculate and factor it into your business.

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Understanding the Cost of Goods Sold

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Cost of Goods Sold (COGS), is the total expenditure and expenses incurred directly or indirectly to produce a product or service, including costs such as labor, materials, and overhead, a process needed by your business to determine the COGS for each item sold to be able to accurately calculate its profit. 

As such, COGS should be set to align with the target marketplace and be acceptable to the consumer.

Although the COGS process seems to be straightforward, if processed incorrectly, your company could suffer losses, therefore it is important to understand that each COGS cost is directly related to a specific product sold by the company, and as such, COGS needs to be established so that your company can accurately know the detailed costings of that particular product.

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Importance of Calculating Cost of Goods Sold (COGS)

COGS is used as a benchmark to assess the desired earnings and anticipated profit of your business, as well as determining the selling price of the products or services offered. 

Your company needs funds to pay the employees who handle the COGS processes, as well as other operational activities. As such, COGS can inform your company how much profit can be made, which can then be used to calculate operational costs.

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3 Main Components of COGS

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There are several important components in COGS. The following highlights some of these:

1. Beginning Inventory of Merchandise

Beginning Inventory of Merchandise refers to the inventory at the beginning of your company’s accounting period, such as April 1 in a calendar year.

The balance of this Beginning of Merchandise Inventory can be checked through the trial balance of the current period, or through the balance at the start of the previous year, such as April 1.  

2. Ending Inventory of Merchandise

The Ending Inventory of Merchandise is the merchandise available at the end of the company's accounting period or the end of the current fiscal year, such as March 31, assuming that your accounting year started April 1.

The value of the balance for this component can be found in the company’s adjustment data at the end of the accounting period, such as March 31. 

3. Net Purchases

Finally, net purchases in COGS include all merchandise purchases made by the company, whether in cash or on credit. 

This figure includes freight-in costs and is reduced by purchase discounts and returns that are currently happening.

Put simply, COGS has a formula that calculates its value: 

Net Purchases + Beginning Inventory = Ending Inventory.

This is a basic definition of the Cost of Goods Sold (COGS).

COGS is a crucial factor for your business that determines the selling price so you can calculate the profit or earnings obtained by your business.

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