There’s an old story about the fall of a great city. Local leadership was made up of several merchants who put nearly all the emphasis on the goods being exported beyond their borders. Business was good, as these leaders understood the art of the sale and were able to establish their products as some of the best in the land.
Emboldened by this success, the leaders set their sights on foreign markets. Using the same tenacity and tactics, they began to gain footholds in several nations.
For a time, this city seemed unstoppable.
But all great cities must fall sometime. What was it that brought down this one? The fanatical focus on exports led to a lackadaisical approach to imports. The food and raw materials being brought into the city were of lower quality, which took a toll on the residents.
Worse yet, some of the carts coming into the city were carrying rats. A careful inspection would’ve uncovered the vermin, but the carts were ushered into the city without a second thought.
Disease spread from house to house, and soon the city’s much-heralded exports began to dry up. Ultimately, the city closed its gates and spent years trying to gain stability again.
You might be wondering what this story has to do with your business. The fact that if you don’t keep a studious eye on what’s coming in your doors, you’ll never be able to find success with the products going out. There’s a symbiotic nature there, and understanding your cost of goods sold (sometimes abbreviated as COGS or referred to as cost of sales) will help you keep tabs on some of the most important elements of your business.
What Is Cost of Goods Sold?
In its purest form, cost of goods sold is the cost to your business for the products you sell. Once you’ve identified this crucial business expense, you’ll be able to shine a light on other areas of your accounting. For example, by subtracting your cost of goods sold from your sales revenue, you’ll discover your gross profit. Likewise, your cost of goods sold is an important component when calculating inventory turnover.
Whether you purchase finished products to then resell or buy materials in order to manufacture your own products, you simply can’t run a successful business without understanding your expenses. Not only that, but you can’t even fill out an income statement without the insights afforded by your cost of goods sold.
How to Calculate Cost of Goods Sold
We’re all seeking better profits, right? So to get a bead on your profits, you’ll first need to crunch the numbers to reveal your expenses. Let’s look at some common examples of what would be included in your cost of goods sold:
- Raw materials
- Items needed to finish a product
- Direct labor
- Finished products to resale
- Things needed to sell a product
- Distribution costs
You’ll notice that this list contains expenses that are closely tied to the making and selling of your products. There are indirect costs, such as marketing, sales, and overhead, that you wouldn’t include in your cost of goods sold formula. They’re still important to consider, but they aren’t involved directly enough to be added to this metric.
The cost of goods sold formula is one of the most user-friendly in business accounting. You just add your beginning inventory to the cost of your goods, then subtract the ending inventory.
Here’s how the cost of goods sold formula looks when written out:
(beginning inventory + purchases) – ending inventory = cost of goods sold
As you can see, you’ll need to do some homework in advance to ensure you have a firm understanding of your inventory levels and expenses. The “beginning inventory” refers to your inventory’s value at the start of the accounting year. With “purchases,” you’re accounting for any money you spent to buy or make goods during that same time period. And, finally, your “ending inventory” is the total value of your business’s inventory once the accounting year wraps up.
A Cost of Goods Sold Example in Action
Let’s see how knowing how to find the cost of goods sold helped a beauty care business called Olmec Skincare. As with the ancient city that focused on exports, Olmec Skincare had similarly neglected its imports. This wasn’t anything intentional. The monumental tasks of developing quality products and then advertising them to customers had just slowly consumed too many resources.
As the owner of the business, Jasmine began to worry that expenses were becoming an issue. So she sat down in her office one night to figure out the cost of goods sold.
At the beginning of the year, Olmec Skincare’s inventory was valued at $30,000. At the end of the year, it was valued at $15,000. Total purchases during that time were $21,000. These expenses included the special mud from Tanzania that was used in nearly all of Olmec Skincare’s products, as well as the labor required to craft the finished products and then ship them to customers.
So here’s what the cost of goods formula looked like for the business:
($30,000 + $21,000) – $15,000 = $36,000
Jasmine knew that if the cost of goods sold and labor costs totaled more than 65% of her gross revenue, her business could be in trouble. Further analysis revealed that indeed, the cost of goods sold was too high. Even though Olmec Skincare was attracting solid business from customers in 8 countries, the expenses associated with manufacturing and shipping their products were hurting the bottom line.
At the heart of this accounting quandary was Jasmine’s commitment to quality. She was passionate about Olmec Skincare’s products being the best on the market, which is why she insisted on using the expensive Tanzanian mud in the manufacturing process.
But the accounting never lies—and Jasmine’s approach was clearly unsustainable. So she got scrappy. She scoured the internet and found a top-grade mud from Arizona that would achieve the same results as the Tanzanian version. Best of all, it cost 40% less.
After placing orders and testing the new mud, she officially made it part of the manufacturing process. Then she turned her eye to the fulfillment side of the business. A fellow entrepreneur recommended more affordable packaging than had been previously used for Olmec Skincare shipments. And Jasmine decided to keep the packing materials from the Arizona mud shipments and reuse them for her outbound shipments.
The result? Olmec Skincare cut their expenses in half the following year. By leveraging cost of goods sold as a barometer of business health, they were able to identify problem areas and find solutions.
Here’s what the cost of goods sold formula looked like after Jasmine spent a couple of years refining her processes:
($32,000 + $11,000) – $15,000 = $28,000
Putting Your Cost of Goods Sold to Use
Even if you had a business that operated with only a few small expenses, you’d still need to calculate your cost of goods sold. First, it enables you to figure out other accounting metrics that are essential to your business.
Second, tax law dictates that if your business makes or buys products and then sells them, you need to calculate the relevant cost of goods sold before you can write off any of the related expenses. This connection between your expenses and your write-offs is a bit of a two-edged sword: you’ll have a lower tax bill if your cost of goods sold is high, but it will also mean that your profits are taking a hit.
In order to avoid the profit-killing power of expenses, you need to rein them in through actions such as those taken by Jasmine. Seek out more affordable suppliers and more efficient manufacturing processes. Look for ways to save on shipping. By reevaluating every step in your business processes, you’ll be able to chip away at your costs and simultaneously boost your profits.
If you’re interested in more business-building strategies, visit our library of free entrepreneurial courses. You’ll find advice on how to finance your inventory, choose the best products, negotiate better pricing, improve your advertising, and increase your profits.
Each of these courses is taught by entrepreneurs who have walked the same path you’re on. Using hard-earned lessons and advanced tactics, they’ve established legacies of excellence. And now they’re willing to share their secrets with you.
By adapting these lessons to your own business, you’ll be able to expedite your learning and start seeing better results. There’s never been a better time to give your business this valuable boost.