How to Calculate the Cost of Goods Sold
Want to know if your inventory-based business is turning a profit? You need to determine your cost of goods sold, or COGS. Calculating your cost of goods sold tells you how much it costs to create a product—so if you know your COGS, you know what price to sell your goods at to turn a profit.
If you're ready to dive right in, here's the COGS formula:
Cost of goods sold = beginning inventory + purchases – ending inventory
Of course, rather like the pure and simple truth, easy mathematical equations are rarely easy and never simple. Keep reading for our breakdown of each part of the COGS formula.
Understanding the COGS formula
Before you can calculate your cost of goods sold, you need to gather information on three crucial figures over a given time period:
- Your beginning inventory, which is the total worth of all the inventory you have on hand at the start of the time period (including raw materials for not-yet-assembled goods, among other things)
- The total cost of purchases made over that time period, which refers to any new inventory and materials you purchased plus any other direct expenses (expenses directly related to product creation)
- Your ending inventory, or the total worth of your remaining inventory at the end of the time period
The time period you pick is up to you, but we recommend calculating your cost of goods sold at least quarterly. Running the formula once a month is a great way to stay on top of inventory costs—a particularly good idea if you've just gotten your business up and running. And you'll need to calculate your yearly COGS to accurately file your taxes at the end of the year.
Own a retail business? Determining your beginning inventory's value shouldn't be too complicated. For example, if you were a fabric store owner, you'd know exactly how much you paid your supplier for each bolt of cloth or skein of yarn. You'd simply add up how much it cost to acquire each product and, voilà, you've found your beginning inventory's total value.
If you don't just sell goods but also assemble raw materials to create goods, your inventory will include all the building blocks that make up your final product. For example, if you own a smoothie food truck, the cost of your frozen fruit would count as inventory.
Your purchases section should include all direct expenses, or expenses that relate directly to production. Common direct expenses include the following:
- Wholesale inventory purchased during the time period
- Parts and materials
- Direct labor costs, or the wages you pay employees who assemble your products
If you can't directly tie a cost to product creation, it's an indirect cost that isn't included in your total purchases column. For instance, administrative costs (like board member salaries) are indirect costs that don't relate to the COGS formula. (You'll record indirect costs on your income statement, but again, they aren't relevant to calculating COGS, so feel free to set them aside for now.)
Calculate your ending inventory using the same guidelines we outlined in the beginning inventory section above.
Alas, if this is the first time you're running a COGS formula, you'll have to calculate both your beginning and ending inventory. But from this point forward, you'll need to calculate only your ending inventory. Why? Because one period's ending inventory will always equal your beginning inventory for the next period.
Applying the COGS formula
COGS is an essential part of your company's profit and loss statements, one of the most crucial financial documents for any growing business. Profit and loss statements, which are also called income statements, list your revenue and expenses to calculate your net profit.
In turn, the net profit shows you, your investors, and other financial stakeholders (like banks) exactly how financially healthy your business is—which influences who invests in your business and how much.
A basic profit and loss statement has two main sections:
- Revenue, which usually refers to profits from sales of goods or services
- Expenses, which include wages for direct labor, equipment purchases, rent, and (for inventory-based businesses) COGS
At the bottom of the sheet, you'll subtract your expenses from your revenue to list your net profit.
Multi-step profit and loss statements are a little more complicated. Instead of listing COGS as an expense, these types of statements deduct COGS directly from sales revenue to calculate the business's gross profit. The statement then divides expenses into operating expenses (OPEX) and non-operating expenses.
Income statements are one of the three most important financial documents in your repertoire—and learning how to draw one up is a crucial step in understanding your business's financial trajectory. To get more info on how to build your own report, check out our page on how to prepare an income statement.
Cost of goods sold FAQ
Does my business need to calculate COGS?
The cost of goods sold applies only to businesses that sell products. If your business is service based (like a psychology clinic or legal team), your direct costs don't come from sales of goods. Instead, your direct costs are any expenses related directly to your service. For instance, an outsourced accounting company would likely include its accounting software subscription as part of its direct costs.
What is the formula for COGS?
The formula for calculating COGS is beginning inventory + purchases – ending inventory.
What costs are included in the cost of goods sold?
Any costs that directly relate to selling your product should be considered part of your cost of goods sold. For example, if you pay employees to assemble your product, both the product's raw materials and the employees' wages are included in your cost of goods sold. These expenses are also known as direct expenses since they relate directly to your product's creation.
Nothing beats the peace of mind you get from knowing exactly where your business stands financially—and if you own an inventory-based business, calculating your cost of goods sold is a crucial part of that financial serenity. Make sure to run the equation frequently to ensure your business is comfortably in the black or, if not, show you what changes you need to make to boost your profitability.
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