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The Facts Behind the Figures: Determining the Cost of Goods Sold

The Facts Behind the Figures: Determining the Cost of Goods Sold

By Marco Carbajo, Guest Blogger
Published: May 12, 2015

Do you know all of the expenses involved in making your product or delivering your service? If so, then you know what your Cost of Goods Sold (COGS) is. In a nutshell, COGS drives profit – it tells you the expenses you have each time you make a sale.                                                                                        

Before products are sold they might sit in a storeroom or display for an undetermined period of time. Obviously, they are not making you money during this time, but they are still costing you money. It’s for this reason that the COGS is calculated. The COGS is an important figure on your profit and loss statement. For most companies, it's the largest expense – and a critical figure in determining net income.

What it costs you to do business is critical not only in determining your income, but also for making decisions for the effective management of your business. It will also help you keep track of the flow of inventory as it moves through your business. The good news is that you can determine COGS using a simple formula:

Beginning inventory + inventory purchases – end inventory = cost of goods sold

Units Sold

Any business owner should know how many product units his business has sold. There are several ways of doing this, but it all boils down to determining what inventory you have on hand at a given time. To arrive at this figure, you need to know how many units of finished goods you had on hand in your beginning inventory. To this figure you add the number of units created or added to that inventory during the period. Next, you subtract the number of units that make up your ending inventory.

Let’s say you run a dairy farm, for example.  If you begin the accounting period with 400 gallons of milk, and during the period your cows gave you 3,900 gallons of milk, and at the end of the period you have 100 gallons of milk, the amount of milk you have sold would be 4,200 gallons.

Calculating the Cost of Goods Sold

When you finally arrive at the number of goods you have sold, you need to determine what it cost you to create those goods. There are three methods of doing this –FIFO, LIFO, and Average Cost. This is important to know because while you may have a given number of units on hand, that doesn’t mean you paid the same price for each unit. For example, let’s say you sell shirts from a single vendor and that vendor charges you $3.00 per shirt. But in the middle of the month, he increases what he charges you to $3.50. If you sell 100 shirts, is your cost of goods sold $300 or $350? It depends on how you cost your goods.

FIFO, or "First In, First Out," assumes that the first products in are put out first. In the example above, you would assume that the $3.00 shirts were sold before the $3.50 shirts.

LIFO, or "Last In, First Out," assumes that the oldest units of inventory are sold first. In our shirts example above, you would be assuming that your $3.50 shirts were sold before the $3.00 shirts.

Average Cost is just what it sounds like. First you take the beginning inventory plus purchases in dollars. Next, this figure is divided by the beginning inventory plus purchases in units. The result of this calculation is the average cost per unit. Next, you take the average cost per unit, and then subtract the number of units sold. The resulting figure is the COGS.

Anyone who is debating the best way to determine COGS should not be misled into thinking that this is simply a theoretical concept – it is very real. Further, it can be of great use in determining how much money you have really made for your business efforts. Remember, COGS drives profit!

About the Author:

Marco Carbajo
Marco Carbajo

Guest Blogger

Marco Carbajo is a business credit expert, author, speaker, and founder of the Business Credit Insiders Circle. He is a business credit blogger for Dun and Bradstreet Credibility Corp, the SBA.gov Community, About.com and All Business.com. His articles and blog; Business Credit Blogger.com, have been featured in 'Fox Small Business','American Express Small Business', 'Business Week', 'The Washington Post', 'The New York Times', 'The San Francisco Tribune',‘Alltop’, and ‘Entrepreneur Connect’.