If you are starting a small manufacturing business, even if you are operating out of your home, there is a concept call Cost of Goods Sold (COGS) that you probably need to be aware of. COGS is the total amount your business paid as a cost directly related to the sale of products. Operators just getting started, whether it’s a mobile sandwich business or you make jewelry in the basement often think that they can call their purchases “supplies” and expense the amount they’ve spent for the year. This is not the proper tax approach.
Depending on your business, COGS may include products purchased for resale, raw materials, packaging, and direct labor related to producing or selling the good. The entrepreneur’s own labor is not a cost that can be expensed. Labor is only what you paid to other people.
In other words, the materials that go into the product and the labor that goes into making each unit may be included in cost of goods sold. If you incur sales costs specific to that item, like commissions, those costs may also be included in COGS. The accounting term for this is direct costs. By contrast, if a cost is general for your business, like rent, a new machine, or general marketing costs, it isn’t a cost 100% dedicated to a specific item. Those indirect costs are considered overhead, not the cost of goods sold.
Aside from just reporting your COGS, it is an important number for business owners and managers to track. That is the absolute lowest price you can sell a product to break even. Any additional margin goes back to covering overhead and eventually profit. If you don’t know your COGS and break-even point, you don’t know if you’re making or losing money.
Your cost of goods sold tells you a lot about your business, including the following:
- How much profit you’re making on each product
- If your product pricing is too high or too low
- Whether you need to find another vendor or supplier
- If you should continue to sell the product at all
Beginning inventory is the value of the raw materials and finished goods in stock at the beginning of the reporting period. In the first year of a business, the beginning inventory is typically zero, but in succeeding years, the previous year’s ending inventory becomes the next year’s beginning inventory number.
Purchases made during the reporting period include all raw materials, components, and merchandise acquired from other parties during the period. Ending inventory is the amount counted as being on hand at the end of the reporting period. The standard formula to calculate cost of goods sold for physical products:
Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold
If you have any manufacturing labor costs or direct sales costs, you can include those as well, but that may not apply to all businesses.
There are several methods to tracking. First in, first out (FIFO) is the easiest method to use. It assumes that the longest held inventory is what’s sold first whenever a company makes a sale. So, if a company paid $5 per unit a year ago and it pays $10 per unit now, when it makes a sale, COGS per unit is said to be $5 per unit until all of its year-old units are sold.
Last in first out (LIFO) is a method that considers the most recently purchased items in a company’s inventory to have sold first. So, if a company paid $5 per unit a year ago and it pays $10 per unit now, each time it makes a sale, COGS per unit is said to be $10 until all of its more recently purchased units are sold.
The averaging method for calculating COGS is a method that doesn’t consider the specific cost of individual units. It doesn’t matter what was purchased when or how a company’s inventory costs fluctuate. Instead, businesses using the averaging method establish an average per unit cost, and then multiply that average by the number of units sold during a particular period in order to determine COGS. If you chose to track your profit and loss monthly, you would have to track COGS on a monthly basis too.
The average method is important because it represents a happy median between the FIFO and LIFO methods. It’s not the most advantageous method for tax purposes, but it’s not the worst, either. And, it’s relatively easy to apply and to use consistently. However, once you select a method, you have to stick with it.
Inventory on hand at the end of the tax year (usually December 31st for self-employed business owners, has to be counted and valued, usually at cost. It makes sense to create as many sub-accounts as necessary to give you as much business analytics as COGS is usually a business’ largest expense. This will give you a fine-grained view of what constitutes this expense and also make it easier to identify cost control measures as your business grows.
If you’re purchase accounting software with a good inventory management system or point of sale (POS) module, most of these calculations will be completed automatically. If not, you or a bookkeeper will need to track inventory and all associated costs separately in order to accurately calculate the value of your inventory and your cost of goods sold. Based on the nature of the product and the sales cycle, it is possible for a small business owner to get their ending inventory down to a low number by each December 31st. Speaking to an experienced bookkeeper may also be helpful.