Cost of goods sold, also referred to as cost of sales, is the total direct costs attributed to producing your sales. It’s found on your income statement.
Cost of goods sold generally includes your variable expenses, such as raw materials or direct labor, and excludes the costs that are general to your company—the overhead and SG&A expenses—such as marketing efforts. However, some businesses may include fixed costs, such as warehouse or storage expenses. The cost of goods sold is listed as an expense line on your income statement because it’s a cost of doing business.
Calculating your cost of goods sold informs your pricing analysts of your breakeven point and pricing strategies.
When you subtract your cost of goods sold from your total sales, you get your gross profit.
When you subtract your cost of goods sold and all other expenses from your total sales, you get your net income.
Here’s how you calculate your cost of goods sold:
Beginning Inventory + Purchases - Ending Inventory = Cost of Goods Sold
Don’t include the direct costs attributed to products/services that weren’t sold.
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Here’s an example using the formula:
Beginning Inventory: $30,000
Goods Available for Sale: $70,000
(Less) Ending Inventory: ($20,000)
Cost of Goods Sold: $50,000
These are four accounting methods to record the inventory you sold in a period:
First in first out (FIFO) means the products manufactured earliest are sold first. Since prices generally increase, with this method, as your lowest priced items sell, your cost of goods sold becomes lower (than the LIFO) and your net income usually increases over time.
Last in first out (FIFO) means the products manufactured latest are sold first. With this method, your highest priced items are sold, so your cost of goods sold is higher (than the FIFO) and your net income usually decreases over time.
The average cost method takes the average price of all of your manufactured products to calculate the value of your cost of goods sold.
The special identification method takes the price of every individual unit you sold. In this method, your business knows exactly which units and their price. This method works best with expensive specialty products, such as real estate, vehicles and furniture.
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Calculating your cost of goods sold and including it in your income statement isn’t required by the generally accepted accounting principles (GAAP). Businesses that sell services and no products usually don’t include a cost of goods sold—they calculate a cost of sales or a cost of services.
The cost of revenue includes your cost of goods sold, along with any other expenses incurred in a sale, such as marketing efforts. Some businesses prefer using cost of revenue because it’s more comprehensive than using cost of goods sold.
Your operating expenses aren’t included in your cost of goods sold. They’re not directly associated with the production of your sales.
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It’s easy for you to incorrectly value your cost of goods sold by overstating or understating your expenses, discounts and obsolete products. When you don’t accurately calculate your cost of goods sold, you risk operating on a business model that’s unprofitable and unsustainable.
They are usually not. However, you can include salaries in your cost of goods sold when the labor is directly associated with the production of the sales. For instance, when you hire contractors, you may decide to include a portion of their wage into your cost of goods sold.
Your cost of goods sold informs you of the total sales required for you to break even. This helps you set your pricing strategy to build a sustainable, profitable operating model.
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