Do you need to calculate the cost of goods sold (COGS) for your business? While this calculation may be unfamiliar to many small business owners, it is vitally important both to really know what type of profit you have made as well as to keep your taxes low.
But how do you come up with this number? The equation itself appears relatively simple, but you will need to know five components in order to do it. Here are those five basic elements and how to determine them.
1. Beginning Inventory. Obviously, you will need to know the value of your inventory at the beginning of the period (usually a tax year). So if you're new to COGS, start by coming up with the prices of the materials you have as well as any finished goods that are available for sale at this time.
2. Inventory Method. Inventory materials generally are not purchased for the same price all year long. In fact, materials like steel and copper vary on a daily basis. This means you must determine which method of "pulling" goods from inventory you will use for tax purposes. You may usually use "last in/first out," "first in/first out," or specific identification of parts. Choose whichever method is most advantageous and stick with it.
3. Other Direct Costs. Direct costs are those items that aren't the actual inventory but are directly related to it or the manufacturing process. It might include freight to get the materials to you as well as packaging expenses, supplies used in production, or maintenance costs of production equipment. These costs should include most things that directly touch or create your goods from start to finish.
4. Indirect Costs. While direct costs are clearly related to the production process, indirect costs are harder to recognize. These costs are still directly attributable to manufacturing but don't necessarily touch the goods. They often include wages and benefits for production employees, costs of the workspace or production building, and administrative costs attributable to making the goods.
5. Ending Inventory. Finally, you'll need to know what you have unsold (in-process and finished) at the end of the year. Use the inventory method chosen earlier. If you chose "first in/first out" method, for instance, your remaining inventory will be valued at the latter prices because the 'first' prices will have been pulled during the year. This ending inventory will become the basis of your beginning inventory next year.
As you learn more about these five key factors, you will learn more about your costs and your profit margins. And the more complete your COGS is, the more it will reduce the company's taxable income. Want help with these calculations? Start by consulting with a CPA business tax accountant today.