For any business to operate successfully, one needs to know exactly what drives profit and what needs to be spent to make an individual sale, otherwise known as Cost of Goods Sold (COGS).
Any unsold product just sitting on the shelf is obviously not making you any money but is also costing you, which is why the COGS is a key figure in determining net income and an important figure on your profit and loss statement. For most companies, it's the largest expense – and a critical figure in determining net income.
What it costs you to do business is critical not only in determining your income, but also for making decisions for the effective management of your business. It will also help you keep track of the flow of inventory as it moves through your business. The good news is that you can determine COGS using a simple formula:
Beginning inventory + inventory purchases – end inventory = cost of goods sold
Any business owner should know how many product units his business has sold. There are several ways of doing this, but it all boils down to determining what inventory you have on hand at a given time. To arrive at this figure, you need to know how many units of finished goods you had on hand in your beginning inventory. To this figure you add the number of units created or added to that inventory during the period. Next, you subtract the number of units that make up your ending inventory.
Let’s say you run a dairy farm, for example. If you begin the accounting period with 400 gallons of milk, and during the period your cows gave you 3,900 gallons of milk, and at the end of the period you have 100 gallons of milk, the amount of milk you have sold would be 4,200 gallons.
Calculating the Cost of Goods Sold
When you finally arrive at the number of goods you have sold, you need to determine what it cost you to create those goods. There are three methods of doing this –FIFO, LIFO, and Average Cost. This is important to know because while you may have a given number of units on hand, that doesn’t mean you paid the same price for each unit. For example, let’s say you sell shirts from a single vendor and that vendor charges you $3.00 per shirt. But in the middle of the month, he increases what he charges you to $3.50. If you sell 100 shirts, is your cost of goods sold $300 or $350? It depends on how you cost your goods.
FIFO, or "First In, First Out," assumes that the first products in are put out first. In the example above, you would assume that the $3.00 shirts were sold before the $3.50 shirts.
LIFO, or "Last In, First Out," assumes that the oldest units of inventory are sold first. In our shirts example above, you would be assuming that your $3.50 shirts were sold before the $3.00 shirts.
Average Cost is just what it sounds like. First you take the beginning inventory plus purchases in dollars. Next, this figure is divided by the beginning inventory plus purchases in units. The result of this calculation is the average cost per unit. Next, you take the average cost per unit, and then subtract the number of units sold. The resulting figure is the COGS.
Further, it can be of great use in determining how much money you have really made for your business efforts. Remember, COGS drives profit!
This article is a re-blog of SBA.gov's Marko Carbajo