Shared by Lynn Wise of Contractor In Charge:
Operating a business comes with numerous challenges and responsibilities, according to the pros at Contractor In Charge. One of the most important things that new business owners must understand is how their business accounts and financial statements work. If you’re starting a business or thinking about doing so, understanding accounting terminology is an essential first step in making sure your company is set up for success. In the business world, cost of goods sold (COGS) is a term that you’ll see frequently. In general, COGS refers to the costs associated with producing or acquiring products sold by a company. At Contractor In Charge, they explain that you can think of it as how much it costs to make something in order to sell it.
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COGS Defined
According to Contractor In Charge, COGS, or cost of goods sold, measures the total costs associated with producing a product or service that has been sold. It usually refers to products rather than services. COGS is useful for businesses to understand their break-even points and how their products are priced. Knowing COGS can help you price products more accurately based on your production costs.
What Is Included in COGS?
COGS calculates how much it costs you to produce and sell your goods. Contractor In Charge gives an example that if you purchase raw materials to make a product, then pay someone to assemble the raw materials into a product, the COGS of that product would include all those costs. COGS typically includes the cost of the raw materials, the labor associated with making the product, any additional materials used in production, and any overhead expenses associated with production.
Why is COGS Important?
COGS provides an indication of how much a company is spending on production and what it costs to make a product. Contractor In Charge notes that understanding this can be crucial for companies that are trying to break even, since knowing COGS can help businesses set the right price for their products.
If COGs are too high, then a company will have a hard time breaking even — and if COGS are too low, the products may be priced too high. COGS can also be important when it comes to making decisions and projections. If a company is trying to expand production and anticipate how much it will cost, knowing the COGS of the products will help determine how much the company will be spending on materials, labor, and other production costs.
Image credit: Artem Podrez
How to Calculate COGS
Calculating COGS can be a little tricky. Here is a basic formula based on a retail establishment’s inventory from one tax year. At the beginning of their year, their inventory was valued at $25,000. During the year, they purchased $10,000 more In products to resell. At the end of the tax year, they still had $5,000 worth of remaining inventory.
COGS, in this case, is the starting inventory, plus purchases made during the year, minus the ending inventory.
COGS = $25,000 + $10,000 – $5,000
So, their COGS is $30,000.
If the company made $65,000 in revenue that year, they can calculate their profit by subtracting COGS from their revenue:
Profit = $65,000 – $30,000
So, their profit is $35,000.
Bottom Line
When you’re operating your business on a daily basis, it can be easy to forget about the big picture. However, Contractor In Charge notes that it’s important to make time to review your business’s financial statements and numbers on a regular basis. COGS will change over time as different products are sold. As your COGS change, you can adjust prices to make sure your business remains profitable. And when you have a better understanding of your COGS, you can make more informed decisions about your business and future growth.