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How to Calculate Cost of Goods Sold?

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Are you having blooming business ideas in mind? Thinking to start one soon? Businesses that provide services are much different from manufacturing businesses. When it comes to a manufacturing business, you have to master your plan of action that may include a suitable place for business, an investor, and a piece of machinery or equipment necessary for production. Along with the workers’ team, you will also have an accountant or CA who will properly guide you. However, you must know many fundamental notions before jumping into this vast ocean. The Cost of Goods Sold Formula is cherry on the cake that will help you determine your business’s productivity.

Cost of Goods Sold Definition

The Cost of Goods Sold is the result that shows how much it costs to produce or manufacture a product for a given period. Though it sounds straightforward, calculations can be complicated depending upon the type of business that is being operated. For example, a retailer not directly associated with manufacturing can easily calculate the Cost of Goods Sold Formula since they have a transparent idea of what materials and inventory are required for the calculation. On the other hand, a manufacturing industry that deals with pieces of machinery and labour will have a much tricky calculation.

This is to be noticed that the calculation involves only direct labor and direct material expenses that go into the production of every single product that is being sold in the market. The cost of goods that are not intended to sell cannot be included here.

How do we calculate the Cost of Goods Sold Formula?

Here, you will come across a term called ‘inventory.’ The inventory indicates what you are selling. Therefore, an inventory may be anything you have manufactured or purchased from a wholesaler for reselling.

You can calculate it using a simple equation

Starting inventory + purchasesending inventory = Cost of Goods Sold

Here,

Creating an inventory is the cost of the materials in your inventory at the beginning of the year. It has to be the same as the ending inventory at the end of the previous year.

Purchases denote the cost of any item related to the inventory over the year. This includes the cost of labor and cost of materials and supplies.

Ending inventory is the cost of all the items at the end of the year.

To derive the Cost of Goods Sold, you have to follow three steps:

First, you have to consider the direct and indirect costs of the particular quarter or year. Direct cost refers to the cost of labor and materials used, whereas indirect costs include rent, salaries of employees indirectly associated with the production, electricity consumption, storing cost, etc. In this way, you will be able to tally the starting inventory.

The second part includes the addition of additional purchases. You have to tabulate all the purchases made over the period or quarter. These additional purchases will be added for the derivation of the formula. If there is any return from the customer or products taken from personal and family purposes, this will not be considered and needs to be subtracted from the purchases.

The last part is tallying the Ending inventory of the quarter. After following the above two steps, you will already have a clear conception of Goods Sold’s Cost. This last step is just the replica of the first step. The cost of inventory at the end of the year requires a necessary calculation to obtain a perfect result.

Accounting method and Cost of Goods Sold

Whether you are the manufacturer or the wholesaler, the one fact that you will face is-Prices of products or raw materials are not constant. This implies that your stockroom products are more worthy or less worthy, depending on when they were produced or taken.

For this reason, to take care of the stock of your company’s inventory an accounting method is the best practice.

You have three choices:

1) FIFO or First-In, First-Out

In FIFO, you have to consider that the inventories produced first are sold first.

2) LIFO or Last-In, First-Out

In LIFO, you have to consider that the newest inventories i.e., the inventories produced last are sold first.

3) Average cost

The heading explains it all. Here, you have to consider two things. First is the currency and second, units of production. You will calculate the total amount of the starting inventories and the additional purchases. Then, you tally up the number of production units made along with the number of units you purchased over the quarter. Just divide the currency inventory figure by the unit inventory figure and you will get the average cost per unit of the product.

Thus the detailed form of Cost of Goods Sold Formula looks like this as per IRS-

Costs of Goods Sold = (Inventory at the starting of year + Net Purchases+ Labor cost+cost of materials+ other costs)- Inventory at the end of the year.

Let’s analyze by the Cost of Goods Sold Example:

The practical way to understand this topic is going into detail by the Cost of Goods Sold Example. This will show a vivid picture of the way of calculation and clear the concept if you have any doubts.

Let’s Start.

Say, XYZ is a manufacturing company. The financial year of the company ends on 31st March. Here we are considering the financial year from April of the previous year to March of the recent year.

On 1st April 2016 starting inventory was $ 20,000 and the ending inventory on 31st March 2017 was $5000. During the full financial year, the company made purchases of $ 7000. You have to calculate the Cost of Goods Sold during the financial year ending on 31st March 2017.

Solution:

Using the above figures, the Cost of Goods Sold can be calculated for XYZ company for the financial year ending ion 31st March 2017.

We know,

Starting inventory + purchases ending inventory = Cost of Goods Sold

As per the data provided,

$20000 + $7000$5000

= $27000$5000

= $22000

Let’s see another Cost of Goods Sold Example:

A company, say ABC, at the beginning of the calendar year 2014 started to purchase and sell shirts in the market. The total purchase made was $ 25,000 during the period. Goods worth $ 5,000 are in the closing inventory by the end of the year, i.e. on 31st December 2014.

Solution:

We know,

Starting inventory + purchasesending inventory = Cost of Goods Sold

As per the data provided,

$0 + $25000 –  $5000

= $25000$5000

= $20000

Cost of Goods Sold Formula is the way to measure your profit. A more convenient Cost of Goods Sold will help to draw the attention of the investors. It will also show you a more remarkable figure for the gross income of the company.

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