Knowing what you are spending is essential to maximizing what you will earn. Apart from keeping an eye on your operational costs and other businesses expenses, you should also understand how much does it cost you to produce (source) your products or deliver a standard service.
You need to calculate cost of goods when:
Wait, what is cost of goods sold?
Cost of goods sold (COGS) is that final number you receive when adding up all the costs involved in creating and selling a product (or a service). Often enough you will also see the term “cost of sales”. It has the same meaning as COGS. Cost of sales is something a retailer, service provider would use. And a manufacturer would likely coin “cost of goods sold” term.
Let’s illustrate this with two quick examples.
For example, you have a candle making business. You buy beeswax from a local farmer, and it costs you around $2 per candle. Then you order some essential oils. One bottle priced $8 is enough for 10 candles. So in total, it costs you $2.8 to produce one candle. At some point, you decide to hire an assistant. You pay her $15/hour and she makes 10 candles. So it’s another $1.5 towards manufacturing costs.
So it costs you $4.3 to produce one candle = your cost of goods sold.
Why calculating your COGS is so important? Because you can deduct those costs for tax purposes. IRS allows you to add a variety of different costs to calculate your gross profit, and then estimate taxes on that profit. This is one of the key prep steps for tax season.
But what if you don’t produce any goods, just sell them? Here’s a cost of sale example for you then.
At the beginning of the month, you have $1,500 worth of inventory left over from last month. You decide to order $5,000-worth of additional merchandise. You had a good month sales-wise and sold $4,000 of products. Here’s your cost of sales formula will look like:
- Beginning inventory – $1,500
- Plus Purchases – $5,000
- Minus Ending inventory – $2,500
- = Cost of sale $4,000
In a nutshell, COGS is your cost of doing business. It’s an expense that reduces your net income (profit). One hand, that’s great – you have fewer taxes to pay at the end of the year. On a less fun note, if your COGS is high, you are not making much money (and something needs to be changed!). Perhaps, you should give better price quotes for your projects?
In any case, you should know how to calculate cost of goods sold. So let’s tackle this together.
Cost of Goods Sold Formula: Step-by-Step Breakdown
First, let’s recap the basics. To apply the formula you will need to prep the following numbers first:
- Beginning Inventory Costs. That’s how much merch you have left at the beginning of the year. If you have just launched your biz and didn’t purchase anything yet, that would be zero.
- Additional Inventory Costs. The grand total of everything you have purchased during the year.
- Ending inventory. How much worth of goods you have left at the end of the year.
So the simplest cost of goods sold formula will look like this:
Beginning Inventory Costs + (Additional Inventory Cost + Cost of Purchases/Materials For Items Sold During the Year)– Ending Inventory
= Cost of Goods Sold
COGS formula accounts for the two groups of costs:
- Direct Costs – everything you spend on manufacturing or purchasing your products.
- Indirect Costs – costs related to shipping, labor, equipment etc. (mentioned in the first example).
How to Determine Direct Costs
This one’s rather straightforward. If you are a product business, those will include:
- Cost of raw materials for production (e.g. beeswax)
- The cost to purchase merch for re-selling (e.g. if you are dropshipping from AliExpress)
- Packaging costs
- Direct overhead costs related to production (e.g. utilities and rent for your manufacturing facility)
- Cost of inventory of finished products.
If you run a service business, you do not have inventory per se. You can record your direct and indirect costs as expenses on the income statement. (More on this later in the post!).
How to Determine Indirect Costs
This group of expenses includes:
- Labor costs (only for people directly engaged in manufacturing). An assistant helping you with making candles or baking cookies counts. A freelance marketing manager doing some promo work for your biz – nope.
- Warehousing costs. Everything you pay to store/wholesale your goods.
- Depreciation of equipment. Again, only those you use to produce, package and store your goods.
- Salaries of production-involved staff. Do you have a manager running your facility? Or a foreperson dealing with equipment? If yes, capture their salaries as an expense.
How to Determine Beginning Inventory
Your inventory consists of merchandise in stock, raw materials, working in progress, finished products and supplies for producing your items. The beginning inventory should be equal to your ending inventory last year. If there’s a mismatch in numbers, the authorities may have questions.
How to Determine Your Ending Inventory
These costs are typically determined by either estimation or a physical inventory of products. Note: you can account for damaged and worthless items here. If a bunch of your goods were damaged due to some accident, you can report the estimated value. To claim worthless inventory, you will have to provide evidence that it was destroyed.
How to Valuate Your Inventory
There are two acceptable methods for determining which inventory is left at the end of the year:
- LIFO (Last in, first out)
- FIFO (first in, first out)
Important Note: It’s best to consult with a tax advisor/professional accountant when selecting either of these methods. IRS has different guidelines for businesses using FILO/LIFO that you will have to follow.
So here’s how to figure out cost of goods sold. Add all the collected information above in a spreadsheet, group it into respective categories and apply the COGS formula. If you have troubles with the numbers, it’s best to ask an accountant for help!
Cost of Revenue: COGS alternative for Service Businesses
As a service business, you do not have direct product manufacturing costs. So the standard COGS formula doesn’t really work for you.
But you can calculate your cost of revenue – all the direct costs associated with the services your company provides. Indirect costs (e.g. salaries) are not included.
That cost of revenue number should go on your company’s income statement and help you properly calculate your gross profits (and report expenses).
The easiest way to determine what counts as a cost of revenue and what’s not is to ask yourself this question:
“Will I incur this expense if I did not make a sale today?”
If yes, that expense should go towards your cost of revenue. For instance, you run a pool cleaning business. Here are the costs you can capture:
- Direct Labor. You have signed up a new client for cleaning their pool once a month. It’s a 3-hour job for one guy. He’s paid $15/hour. So you will have $45 indirect labor costs that you can include in the cost of revenue.
- Sales commission. Let’s say you pay a local real estate agent to pitch your services. She gets a 10% cut for referring a paying client. Considering that you only incur this cost when making a sale, it should be included in your cost of revenue.
- Shipping costs. As a lawyer, you regularly mail various legal documents to your clients (at your own expense). For one client, those courier/shipping costs round-up to $45/month. Again, these can be included in the cost of revenue.
What’s Not Included in Cost of Revenue
- Employee salaries. These are not directly tied to revenue. Whether you make a sale or not, you will still have to give your receptionist, sales manager and everyone else a paycheck at the end of the month.
- Office rent. That’s an overhead cost that should be reported as a business expense. Don’t add it up to cost of revenue.
- Utilities. In general, these are not considered as part of cost of revenue for service businesses.
- Phone. Again, you will have to pay the bill no matter how many conversations with prospects will lead to a sale.
Cost of Revenue Formula and Example
Now that you know what to include, let’s calculate your cost of revenue per unit/service. The general formula is simple – you just add up all the costs you incur while providing a particular service.
For example, you have secured a $4,500 floor renovation job. You need 2 people to do the job in 24 hours (3 business days). Further breakdown:
2 woodworkers x $25 = $50 per hour and $1200 total.
10% of $5,000 job = $500 sales commission
0.50 cents x 300 miles = $150 x 3 days = $450. Fuel costs for getting your guys and equipment to the client’s place every day.
So your total cost of revenue rounds up to $2150. And your gross profit respectively is $2350 for that job.
Calculating your COGS and cost of revenue isn’t that fun (unless you are into numbers). But they both give you better insight into your business financial health and help find new ways for optimizing your operational costs and increasing your profit margin!
Photo by stevepb.