Some brands purchase and resell inventory items to customers, while others manufacture the goods they sell. Both types of businesses spend money on inventory, but there are more differences than similarities — especially in figuring out how to calculate their cost of goods sold (COGs).
Since COGS is a key factor in figuring out profit margins and it also affects your income statement, it’s vital to use the correct method to calculate it based on your business model. With 58% of retailers expecting to be more profitable in the next two years, small business owners and product sellers can’t afford to ignore cost tracking and optimization.
Cost of goods sold, abbreviated COGS, is the direct costs generated by producing or purchasing the goods and services a company sells to generate revenue.
In other words, it’s the expenses directly tied to making or purchasing your company’s products during a specific period. Indirect costs like administrative expenses, office supplies, and similar business expenses are excluded from the calculations.
It’s a straightforward concept but can look different depending on whether you purchase or produce your inventory. Let’s take a look at the process for calculating inventory costs for these two business scenarios.
The basic formula for COGS is:
COGS = Beginning Inventory + Purchases During the Period – Ending Inventory
This formula is used by resellers who purchase rather than manufacture their inventory.
Manufacturers, however, use a different formula because they are producing goods, not just acquiring them. This means they have additional variables and fixed costs to consider, like factory overhead, raw materials, and labor.
COGS for manufacturers = Raw Materials + Direct Labor Costs + Utilities + Direct Overhead Expenses
Whichever formula you use, COGS can be calculated manually, with spreadsheets, or automatically through inventory management software like Cin7. While automating this calculation is faster, easier, and more accurate, it’s helpful for business owners to understand what goes into calculating cost of inventory so they can improve decision-making and discover areas to optimize COGS.
To calculate COGS, determine which formula applies to you: basic or manufacturing. From there, plug in the values for your inventory value or costs. Remember that your inventory values may vary depending on your inventory valuation method, like last in first out (LIFO) or first in first out (FIFO).
Here’s a closer look and an example for each type.
Resellers use the basic formula: COGS = Beginning Inventory + Purchases During the Period – Ending Inventory, where:
Let’s look at an example using a shoe seller to see it in action.
The company would plug those numbers into the basic COGS formula to get their COGS for a given time period.
COGS = $10,000 (Beginning Inventory) + $30,000 (Purchases) – $5,000 (Ending Inventory)
COGS = $35,000
For the example year, this brand’s COGS is $35,000.
Cin7 can automate COGS calculations for resellers by automatically tracking the COGS per unit at the time of sale. This lets you track COGS on an ongoing (or perpetual basis), so you don’t have to wait until the end of an accounting period to understand this key metric.
To better understand the COGS calculation for manufacturers, imagine a company that builds and sells wooden tables. Their COGS formula, Total COGS = Raw Materials Cost + Direct Labor Costs + Utilities + Overhead Expenses, requires considering the following manufacturing costs for any given period:
Now, assume this table company sold 100 wooden tables over the quarter. The costs associated with those 100 tables were:
The company then enters those values into the COGS for manufacturers formula:
Total COGS = $5,000 (Raw Materials) + $3,000 (Direct Labor) + $500 (Utilities) + $2,000 (Overhead)
Total COGS = $10,500
So, the total production costs for those 100 wooden tables they sold during this quarter is $10,500.
With Cin7, manufacturers can automate job costing so you can track COGS more easily for each customer order.
Understanding COGS is crucial for any business owner, no matter which cost of goods formula you use. These benefits include:
COGS analysis enables informed decisions regarding product lines, suppliers, and production processes. For instance, companies can identify the most profitable products and allocate resources accordingly. Tracking COGS over time also helps the company make strategic decisions about pricing and production, such as reducing bloated costs or streamlining the manufacturing process.
Understanding COGS helps businesses analyze their profitability accurately. With the direct costs associated with producing goods, companies can determine their gross profit margin, which is essential for assessing company health. Implementing efficient manufacturing practices and optimizing resource usage can help lower COGS, improve cash flow, increase profitability, and boost your bottom line.
Tracking COGS protects profitability because it helps inform pricing strategy and uncover opportunities to reduce expenses. This is especially relevant now as 37% of retailers list inflation and rising prices as a top supply chain challenge they expect to see in the next two years.
An accurate understanding of COGS helps businesses set competitive prices for products or services while optimizing their spending. By understanding the cost structure, businesses can ensure they cover their expenses while remaining competitive in the market.
In addition to helping with profitability and pricing, COGS provides insights into inventory management. By tracking COGS over time, businesses can identify trends and optimize inventory levels to minimize holding costs and avoid overstocking or stockouts.
Calculating COGS helps optimize your business, including profitability, pricing, inventory management, and overall strategy. By following these best practices, you can ensure you are getting the most out of COGS data.
Calculating COGS annually instead of continuously results in missed opportunities to adjust profit margins. Past events over the last year could already have impacted your profits before you realize it and have the opportunity to take action to reduce expenses or increase revenue.
To ensure the most detailed insights on expenses and profitability, you should maintain accurate inventory and expense records to consistently calculate COGS. Cin7 makes this easy by automatically calculating COGS for each item sold and offering integrations with multiple accounting software so that you can monitor this expense and profit margins over time.
Implement inventory management software to streamline inventory valuation and COGS tracking. This saves time and reduces errors caused by manual calculations and data entry. Leveraging technology is also essential for keeping up with the competition, as 48% of CFOs plan to invest in automation and AI as part of their cost optimization strategy.
With Cin7, you can enable Connected Inventory Performance to go beyond just tracking COGS and spend more time leveraging insights to reduce expenses, increase profit margins, and grow your business.
Automating COGS calculations reduces manual workflows and saves your team valuable time. That said, it’s important to remember to review the data and insights.
Regularly assess COGS data to identify areas for improvement and make adjustments to enhance profitability. A manufacturer that sees higher COGS due to rising costs of raw materials may use that information to negotiate with suppliers or explore alternative materials that are more cost-effective.
Whether you purchase or manufacture your inventory, there are many benefits to automating your COGS calculation. It reduces manual work, improves accuracy, saves time, and, perhaps most importantly, allows you to monitor and adjust profit margins on the fly.
Cin7 automates COGS calculations for resellers and manufacturers at the time of sale, making it easier to understand this key expense category in real time and use that information to find opportunities to increase profits. See the difference for yourself with a free trial.
