Cost of Goods Sold (COGS): Definition and How to Calculate It

Calculating the cost of goods sold gives a business insight into its performance and helps calculate profit.
Jul 1, 2022

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Cost of goods sold, sometimes referred to as COGS, is the total cost a business has paid out of pocket to sell a product or service. It represents the amount that the business must recover when selling an item to break even before bringing in a profit. Calculating cost of goods sold is simple and can be calculated monthly to keep track of progress or less frequently for more-established businesses.

What does cost of goods sold include?

Cost of goods sold includes any direct costs that a business incurs in the manufacture, purchase and sale or resale of products. This can include costs for:

  • Purchasing items for resale, including shipping.

  • Materials to make or manufacture products.

  • Packaging such as boxes to ship orders.

  • Costs for shipping and freight.

  • Direct labor for making or manufacturing products.

  • Sales costs such as commissions paid to salespeople.

Whether your business manufactures goods or orders them for resale will influence what types of costs you are likely to include.

Some service-based businesses will find it beneficial to keep track of cost of goods sold, but whether it is helpful depends on how a specific business uses inventory. For example, a massage therapist who keeps massage oil, towels and candles on hand to use when providing massages would not need to calculate cost of goods sold because they are not selling the items to customers. Instead, they would include the cost of those items as tax deductions for operational costs.

However, a physical therapist who keeps an inventory of at-home equipment to resell to patients would likely want to keep track of cost of goods sold. While they might use those items in the office during appointments, reselling that same equipment for patients to use at home plays a different role in cost calculations.

🤓Nerdy Tip

Service-based businesses might refer to cost of goods sold as cost of sales or cost of revenues.

What does the cost of goods sold exclude?

Costs of goods sold does not include costs unrelated to making or purchasing products for sale or resale or providing services. General business expenses, such as marketing, are often incurred regardless of if you sell certain products and are commonly classified as overhead costs.

Examples of costs that are not included in the cost of goods sold include:

  • Marketing.

  • Rent or mortgage payments.

  • Utilities.

  • Equipment purchases.

  • Salaries of management-level employees.

  • Insurance premiums.

  • Administrative costs, such as office supplies.

How is cost of goods sold calculated?

Determine the time frame for which you want to know the cost of goods sold. Set a time frame that fits your accounting and business needs to calculate costs. Businesses often choose between weekly, monthly, quarterly and annually, depending on their needs. Some businesses might calculate cost of goods sold for different periods to better understand their business performance.

Figure out the variables. You need to know three variables to calculate the cost of goods sold:

  • Beginning inventory. This is the cost of goods sold for the inventory in which you started the period. For example, if you started with 10 products that cost $100 each to make, your beginning inventory would be $1,000. If you are calculating the cost of goods sold for a new business, your beginning inventory will be $0.

  • Inventory costs. This amount refers to costs incurred for inventory or services during the time, such as direct labor, product purchases and shipping costs.

  • Ending inventory. This refers to the cost of inventory that you did not sell during the period.

Do the math. To calculate the cost of goods sold, use the following formula for your chosen time period:

Beginning inventory + Inventory costs - Ending inventory = Cost of goods sold

Let’s look at an example. Alexis started the month with stock that had a cost of $8,300, which is her beginning inventory. Over the month, she ordered materials to make new items and ordered some products to resale, spending $4,000, which are her inventory costs. At the end of the month, she calculated that she still had $5,600 in stock, which is her ending inventory.

To calculate her cost of goods sold for the month, her formula would be:

8,300 + 4,000 - 5,600 = $6,700

🤓Nerdy Tip

If the formula is confusing, think of it this way. When you add your inventory purchases to your beginning inventory, you see the total available inventory that could be sold in the period. By subtracting what inventory was leftover at the end of the period, you calculate the total cost of the goods you sold of that available inventory.

To calculate your cost of goods sold, use our calculator below.

Why you need to know the cost of goods sold

Calculating profit

Correctly calculating the cost of goods sold is an important step in accounting. Any money your business brings in over the cost of goods sold for a time period can be allotted to overhead costs, and whatever is leftover is your business’s profit. Without properly calculating the cost of goods sold, you will not be able to determine if your business is making a profit.

Adjusting pricing

A business’s cost of goods sold can also shine a light on areas where it can cut back to make more profit. You might be surprised to find that you’re making less profit than you expected with certain products. By analyzing the cost of goods sold for certain products, you can change vendors to order cheaper materials or raise your prices to increase your profit.

Completing financial statements

A business needs to know its cost of goods sold to complete an income statement to show how it’s calculated its gross profit. Businesses can use this form to not only track their revenue but also apply for loans and financial support.