A Beginner’s Guide to Calculating Cost of Goods Sold

I. Introduction

Calculating Cost of Goods Sold (COGS) is essential for all businesses, regardless of their size and scale of operations. This article aims to provide a comprehensive guide to understand the importance of COGS, steps to calculate it, and strategies to avoid costly mistakes leading to better business decisions.

II. A Beginner’s Guide to Calculating Cost of Goods Sold

COGS is a financial metric that determines the total direct expenses incurred in manufacturing or purchasing a product. It includes the amount spent on raw materials, labour, and production overheads. The selling price of the product does not include these direct costs, making it essential for business owners to calculate COGS. This way, small business owners can set the appropriate price for their products or services to ensure profitability.

COGS forms a crucial part of a business’s income statement. It helps in determining the gross profits and the net profits of a business. By subtracting COGS from revenue, business owners can calculate their gross profit margin.

III. The Importance of Accurately Calculating Cost of Goods Sold in Your Business

An accurate calculation of COGS is critical since it impacts various business decisions. Incorrect COGS can lead businesses to price their goods or services inappropriately, which can result in either losing profit or under-pricing the products. Furthermore, it can impact the business owner’s ability to identify which products are more profitable, leading to wrong decisions leading to losses.

Incorrect COGS can also inflate or reduce the net income of the business, which can impact the tax liabilities of the business. Therefore, accurately calculating COGS is critical to meet regulatory and tax compliance, resulting in reduced penalties and late fees.

IV. 5 Simple Steps to Calculate Cost of Goods Sold for Small Business Owners

The following are five simple steps to calculate COGS:

1. Start with the opening inventory: To calculate the cost of goods sold, you need to determine the value of the products that you had in inventory at the start of the accounting period.
2. Add inventory purchases during the accounting period: Next, you must add the value of all inventory that you purchased during the accounting period.
3. Calculate the total COG available for sale: Create a sum of the opening inventory and inventory purchases you made during the accounting period to determine the total dollar amount of goods you have available for sale.
4. Deduct closing stock: Calculate the value of the inventory at the end of the accounting period. By subtracting the closing inventory from the total cost of goods available for sale, you can determine COGS.
5. Calculate COGS: By deducting the total value of closing inventory from the inventory available for sale, you can get the total amount of COGS.

For example, suppose your opening inventory is $10,000, and you have purchased inventory goods worth $5,000 during the accounting period. Your closing inventory is $8,000. You can calculate COGS by using the below steps:

• Inventory available for sale: $10,000 + $5,000 = $15,000
• COGS: $15,000 – $8,000 = $7,000

Thus, COGS is $7,000.

V. Mastering the Formula: A Comprehensive Guide to Calculating Cost of Goods Sold

The formula to calculate COGS is:

• COGS = Opening Inventory + Inventory Purchases – Closing Inventory

Consider a small business that has an opening inventory of $10,000, purchased items inventory worth $5,000, and a closing inventory of $8,000.

• COGS = $10,000 + $5,000 – $8,000
• COGS = $7,000

From the above calculation, the COGS of the business is $7,000.

You can also use this formula to calculate the COGS of individual products:

• COGS per unit= (Direct materials + Direct labor + Manufacturing overhead)/Number of units produced

For example, suppose a business spent $10,000 on direct materials and $5,000 on labor for the production of 2,000 units. The manufacturing overheads were $2,500. The COGS per unit will be:

• COGS per unit = ($10,000 + $5,000 + $2,500)/2,000 units
• COGS per unit = $8.75

VI. Avoiding Costly Mistakes: Tips for Correctly Calculating Cost of Goods Sold

It is crucial to avoid costly mistakes when calculating COGS to ensure accurate financial statements. Below are the tips for correctly calculating COGS:

• Ensure accurate recording: Accurate record-keeping is essential in calculating COGS. Keeping track of inventory, purchases, and sales will help in making precise calculations.
• Take note of all direct costs: Ensure to record all direct costs that include raw materials, labor, and manufacturing overhead.
• Separate direct and indirect costs: Keep separate records of direct and indirect costs. Indirect costs, such as rent and utilities, are not part of COGS.
• Verify the inventory count: Accurate COGS calculations require precise inventory counts. Ensure that inventory counts are correct by conducting periodic inventory audits.
• Use the right accounting method: Choose the best accounting method that suits your business. Using accounting methods that match your operations will provide more accurate and relevant information.

VII. Conclusion

Small business owners need to track their finances accurately, and COGS is an essential financial metric that helps them take the right business decisions. This comprehensive guide covers everything a beginner needs to know about COGS, from its definition to how to calculate it to tips to avoid costly mistakes. We encourage all small business owners to take the time to track COGS accurately to ensure financial success.