Cost of Goods Sold Formula: A Step-by-Step Guide

When selling a product, you need to understand the production costs associated with it in a given period, ​​which could be a month, quarter, or year. You can do that by using the cost of goods sold formula. It’s a straightforward calculation that accounts for the beginning and ending inventory, and purchases during the accounting period. Here is a simple breakdown of the cost of goods sold formula:

COGS = beginning inventory + purchases during the period – ending inventory

To calculate cost of goods sold, you have to determine your beginning inventory — meaning your merchandise, including raw materials and supplies, for instance — at the beginning of your accounting period. Then add in the new inventory purchased during that period and subtract the ending inventory — meaning the inventory leftover at the end for your accounting period. The extended COGS formula also accounts for returns, allowances, discounts, and freight charges, but we’re sticking to the basics in this explanation.

Direct Costs

Direct costs are the costs tied to the production or purchase of a product.

• Direct labor
• Direct materials
• Manufacturing supplies
• Fuel consumption
• Power consumption
• Production staff wages

Indirect Costs

Indirect costs go beyond costs tied to the production of a product. They include the costs involved in maintaining and running the company.

• Utilities
• Marketing campaigns
• Office supplies
• Accounting and payroll services
• Insurance costs
• Employee benefits and perks

The beginning inventory will be the amount of inventory leftover from the previous time period, which could be a month, quarter, or year. Beginning inventory is your merchandise, including raw materials, supplies, and finished and unfinished products that were not sold in the previous period.

Keep in mind that your beginning inventory cost for that time period should be exactly the same as the ending inventory from the previous period.

After determining your beginning inventory, you also have to account for any inventory purchases throughout the period. It’s important to keep track of the cost of shipment and manufacturing for each product, which adds to the inventory costs during the period.

The ending inventory is the cost of merchandise leftover in the current period. It can be determined by taking a physical inventory of products or estimating that amount. The ending inventory costs can also be reduced if any inventory is damaged, obsolete, or worthless.

Now that you have all the information to calculate cost of goods sold, all there’s left to do is plug it into the COGS formula.

FIFO: First In, First Out

The first in, first out method, also known as FIFO, is when the earliest goods that were purchased are sold first. Since merchandise prices have a tendency of going up, by using the FIFO method, the company would be selling the least expensive item first.

LIFO: Last In, First Out

The last in, first out method, also known as LIFO, is when the most recent goods added to the inventory are sold first.

Average Cost Method

The average cost method is when a company uses the average price of all goods in stock to calculate the beginning and ending inventory costs.

Business owners are likely familiar with the term “operating expenses.” However, this shouldn’t be confused with the cost of goods sold. Although they are both company expenditures, operating expenses are not directly tied to the production of goods.

Operating expenses are indirect costs that keep a company up and running, and can include rent, equipment, insurance, salaries, marketing, and office supplies.

The COGS calculation focuses on the inventory of your business. Inventory can be items purchased or made yourself, which is why manufacturing costs are only sometimes considered in the direct costs associated with your COGS.

Another thing to consider when calculating COGS is that it’s not the same as cost of revenue. Cost of revenue takes into consideration some of the indirect costs associated with sales, such as marketing and distribution, while COGS does not take any indirect costs into consideration.

Since service companies do not have an inventory to sell and COGS accounts for the cost of inventory, they can’t use COGS because they don’t sell a product — they would instead calculate the cost of services. Examples of service companies are accounting firms, law offices, consultants, and real estate appraisers.