Imagine you own a company that sells several different kinds of goods. You keep shelves stocked with a variety of items that customers love, which is great for attracting shoppers — but diverse inventory is just one piece of the profitability puzzle.
To help the business flourish and ensure you’re not just breaking even, there’s a key financial concept you need to understand: cost of goods sold (COGS). COGS measures how much it costs to produce the items you sell. With this insight, you can make better decisions about how to manage and price inventory.
In this article, we’ll explore how COGS affects inventory decisions, impacts profitability, and helps businesses maintain optimal stock levels to meet customer demand while minimizing costs. Keep reading to learn strategies for managing COGS and improving inventory processes.
What is cost of goods sold?
Any inventory you have comes with costs, like the labor hours and raw materials required in manufacturing. COGS represents the amount of money it takes to produce the goods you sell over a given period. For example, if your company sells furniture, the COGS would include all the expenses associated with manufacturing each piece, including all the wood, fabric, manpower, tools, and machinery used in the process.
COGS is an important standalone measure to determine pricing and profitability, but it’s also used as an input to calculate a variety of business accounting metrics. For instance, it helps determine your gross profit margin, which represents the amount of profit your business makes. You’ll also report COGS on your income statement.
Knowing your COGS (the cost of goods in stock) is also essential for accurate inventory valuation — an accounting step required by the IRS that measures the value of unsold goods.
How to calculate cost of goods sold
Knowing how to calculate COGS gives a better understanding of a company’s overall financial health, which you can use to optimize business strategies.
First, it’s important to know what is included in the COGS. COGS only takes into account direct costs of production, like what you pay people who help manufacture products. It doesn’t count indirect costs associated with running your business, like what you pay your sales team or the office supplies budget.
With that in mind, use this basic formula to calculate COGS:
COGS = Cost of materials + Cost of direct labor + Other direct costs
Say that your business sells 500 desks in a month. To make those desks, you might have paid for:
- Raw materials like wood, metal, screws, and paint, totaling $10,000
- The labor costs of 10 full-time production line employees, totaling $16,000
- Other production expenses like the software you use to cut parts, totaling $4,000
Adding up all the direct costs involved in bringing those 500 desks to market, your COGS would come out to $30,000.
Which COGS formula you use depends on your costing method, and which costing method you use depends on your business model and industry. We’ll explore a few costing options next, but this is a simple approach.
How to account for cost of goods sold
Here are four methods to calculate your COGS accurately:
First in, first out (FIFO)
With FIFO, you assume that the oldest items in inventory are sold first. Many companies across industries use this strategy to move inventory, especially if they’re selling perishable goods (as selling the oldest items first helps ensure that inventory stays fresh).
To use the FIFO method to calculate inventory COGS, try this formula:
Inventory COGS = Cost of oldest goods x Total quantity of goods sold
Let’s say you sold 25 desks in one quarter. To calculate your inventory COGS using FIFO:
- Determine the cost of the oldest goods. For example, maybe the 50 desks manufactured cost $500 in January and 100 desks cost $250 in February.
- Calculate the inventory COGS. Since FIFO assumes that the oldest goods are sold first, you’d account for all 25 desks sold at $500 each. Multiply $500 by 25 to get the cost of the inventory you sold, for a total of $12,500.
Last in, first out (LIFO)
LIFO is the opposite of FIFO — with this approach, assume that the most recently produced items are sold first. This strategy might work for your company if prices increase over time to accommodate inflation, fluctuating supply chain costs, and other factors.
To get your inventory COGS using LIFO, use this formula:
Inventory COGS = Cost of most recent goods x Total quantity of goods sold
Again, say you sold 25 desks in one quarter. To calculate your inventory COGS using FIFO:
- Determine the cost of the most recent goods. If you manufactured 50 desks at $500 each in January and 100 desks at $250 in February, you’d go with the February numbers.
- Calculate the inventory COGS. Since you assume that the most recent items are sold first with LIFO, you’d value each desk at $250 each. Multiply $250 by the number of desks sold — 25 — to get the cost of the inventory sold — $6,250.
Weighted average cost (WAC)
The WAC method smooths out price fluctuations over time by calculating an average cost for all units of inventory. This approach is particularly useful when inventory units are similar in nature and costs are relatively stable.
Use this formula to find your inventory COGS with WAC:
Inventory COGS = (Cost of all goods for sale / Number of units) x Total quantity of goods sold
Sticking with 25 desks sold in one quarter, this is how you’d calculate your inventory COGS:
- Sum up the cost of all goods. If you made 50 desks at $500 each in January and 100 desks at $250 in February, they’d total $50,000.
- Divide that sum by the total number of units to get the average cost. There are 150 desks, so you’d get $333.34.
- Multiply the average cost by the amount of inventory sold. Selling 25 desks at $333.34 each would get you $8,333.50.
If you use Fishbowl to manage your inventory, note that it only recalculates average cost when new inventory is added to the system. Selling items doesn’t affect the cost of the remaining stock, helping you maintain consistent records. Plus, if you run out of an item, the average cost will reset when you add new inventory.
Specific identification
To use the specific identification method, track the actual cost of each specific item in your inventory. This method is useful for businesses that sell unique or customizable high-value products, like automobiles and jewelry.
Ensure tracking is precise with an inventory management solution like Fishbowl that automates tracking and COGS calculations.
The impact of cost of goods sold on inventory decisions
Getting your COGS isn’t just an exercise in crunching numbers — it’s a powerful piece of data that shows exactly how much it costs to produce each item you sell. This information helps optimize business strategies and boost profits by enabling you to make informed decisions on pricing, inventory management, cost control, and more.
Transform your inventory management process with Fishbowl today
Fishbowl makes calculating COGS simple. And with our QuickBooks integration, our inventory management solutions provide accurate inventory tracking and financial reporting. Streamline COGS calculations, optimize inventory management, and make the most informed financial decisions for your company.
See how our powerful tools can help you achieve better accuracy, efficiency, and profitability — try Fishbowl today.