Cost of Goods Sold: What Is It and How To Calculate

Calculating COGS involves subtracting the cost of beginning inventory from the sum of purchases made during the period under review. It is critical for calculating gross profit, setting prices, and filing accurate taxes. COGS shows the direct cost of producing or delivering your product. COGS usually reflects the costs of keeping your product available and running smoothly.

Inventory calculation methods

COGS represents the direct costs attributable to the production of the goods sold by a company. Cost of goods sold represents the direct costs attributable to the production or purchase of goods you sell during the tax year. It directly determines your gross profit—the money left over after subtracting production costs. It provides a clear and straightforward way to calculate profits based on direct costs but may not give a full picture of the company’s financial health.

That means checking that your accounting software matches your actual inventory, your payout reports, and your bank deposits. Beauty and digital products run higher. It matters because it’s how you figure out your real profit, set the right prices, and file accurate tax returns in both the U.S. and Canada. E-commerce accounting for Canadian sellers doing business in the U.S. who need expert help. Accurate COGS tracking is one of the best ways to protect your margins when costs are rising.

• Beauty and digital products run higher.
• For most online retailers, COGS falls between 20% and 50% of total revenue.
• Poor assessment of your COGS can impact how much tax you’ll pay or overpay.
• Simplified methods (production or resale) allocate costs via formulas—see Regulations 1.263A-1 through -3.
• The revenue generated by a business minus its COGS is equal to its gross profit.
• Margin projections should reflect the business environment as well as internal developments.

Chamber of Commerce Small Business Index (Q4 2025), 53% of retail businesses say inflation is their top challenge. Book gross revenue and fees as separate line items. Revenue was $120,000, so gross profit is $65,000 (54% margin). During inflation, this means higher COGS and lower taxable income.

How to Analyze COGS Margin

In reporting a lower COGS, the company’s profits will be inflated and its performance will look better than it actually is. For example, a cost could be both variable and direct, like the flour used to produce bread. These are split into categories, with some costs falling into several classifications. As the C in COGS represents, this term is about costs. From their perspective, companies generally have an incentive to minimize their COGS, as this will help gross profit to be higher and encourage investors. This means that accounting for inventory is a crucial component of COGS.

Advantages and disadvantages of the cost of sales method

Estimates and judgments affect COGS through assumptions about inventory obsolescence, production yields, overhead allocation rates, and normal capacity. The following exhibit shows where the cost of goods sold appears in the income statement. Given the issues noted here, it should be clear that the calculation of the cost of goods sold is one of the more difficult accounting tasks. The calculation of the cost of goods sold is not quite so simple as the general methods just noted. If there is a physical inventory count that does not match the book balance of the ending inventory, then the difference must be charged to the cost of goods sold. In addition, the cost of goods sold calculation must factor in the ending inventory balance.

If you’re not sure whether your company is accurately calculating COGS or are unsure how to use the financial data from these reports to make more informed strategic decisions, reach out to us below. Having accurate figures for your Cost of Goods Sold is essential to running a profitable business. This would mean you are only making $5.00 gross profit on each sale. After calculating beginning inventory, ending inventory, and inventory-related purchases, you can find the Cost of Goods Sold using the formula deferred rent tax treatment for accounting under current gaap shown at the beginning of this article.

• On the income statement, COGS is subtracted from revenue to calculate gross profit.
• With supply chain issues causing global COGS to jump by as much as 18%, the weighted average method has become more popular.
• As you dig into the details of COGS, you’ll naturally run into some common questions, especially around taxes and operations.
• Company XYZ accounts for its $12,000 depreciation and amortization expense as part of its operating expenses.
• Adam Jacobs is a US and Canadian tax expert with five years of cross-border experience.
• To calculate this formula, it’s important to understand the components that make up this calculation.
• Indirect costs, on the other hand, are overhead expenses remaining after direct costs have been calculated.

Why COGS Is a Critical Metric

Both of these industries can list COGS on their income statements and claim them for tax purposes. Even though all of these industries have business expenses and normally spend money to provide their services, they do not list COGS. Examples of pure service companies include accounting firms, law offices, real estate appraisers, business consultants, and professional dancers, among others. On a company’s balance sheet, inventory appears under the section called current assets. The final number derived from the calculation is the cost of goods sold for the year. The beginning inventory for the year is the inventory left over from the previous year—that is, the merchandise that was not sold in the previous year.

It simplifies inventory accounting and provides a balanced valuation approach, though it may not be as accurate as FIFO or LIFO when prices fluctuate significantly. With LIFO, the newest inventory (last purchased) is sold first, while older inventory remains in stock. Under FIFO, the oldest inventory (first purchased) is sold first, while newer inventory remains in stock. The company’s COGS for the month is $60,000, representing the cost of materials used to manufacture and sell the furniture. Businesses usually conduct a physical inventory count or use accounting records to determine this amount. Any additional goods or raw materials bought during the period are added to the beginning inventory.

Expenses are part of the cost of doing business. COGS is not an asset (what a business owns), nor is it a tax liability (what a business owes). By understanding COGS and the methods of determination, you can make informed decisions about your business. It is a requirement of your income tax filing. COGS include market-driven costs like lumber, metal, plastic, and other supplies that have a cost set by someone else and are, therefore, less under your control.

Failure to account for an applicable cost can give you a false picture of your financial situation and lead to unpleasant surprises later. When in doubt, please consult your legal, tax, or compliance professional. The Content is not a substitute for any guidance that may be provided by a legal, tax, or compliance professional.

Importance of COGS for Businesses

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. While the gross margin is the standard metric used to analyze the direct costs of a company, the COGS margin is the inverse (i.e., one subtracted by gross margin). Generally speaking, COGS will grow alongside revenue because theoretically, the more products and services sold, the more must be spent for production. The gross profit helps determine the portion of revenue that can be used for operating expenses (OpEx) as well as non-operating expenses like interest expense and taxes.

Frequently Asked Questions (FAQs) About IRS Form 1125-A

COGS represents the costs required to produce the goods a company sells. COGS also does not include any inventory that has been manufactured or acquired but not yet sold, since these items have not contributed to revenue. For this reason, inventory accounting methods are a critical component of COGS. This is because COGS is a cost of doing business, so can be deducted as a business expense from the revenue it generates. If you’re unsure which costs to include in COGS, keep in mind that the basic idea is to consider whether the cost would exist if the product hadn’t been produced.

Inaccurate inventory counts are another huge source of trouble. Getting this right is crucial for keeping your books clean and your business healthy. An incorrect COGS number doesn’t just skew your profitability; it can also wave a red flag for the IRS.

That’s why the cost of goods sold (COGS) is a number every founder should understand. Revenue can look impressive on paper, but it doesn’t always mean your business is financially healthy. At the end of the day, COGS is a useful part of the formula when evaluating a company, but should be considered alongside other metrics to paint a larger picture.