This article was originally published on Feb. 22, 2016, and was updated on Jan. 20, 2022. 

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Managing cash flow is critical to the ongoing health of your small business. Unfortunately, many entrepreneurs struggle to do so effectively.

Lending Tree reports that almost 30% of small businesses blame “running out of cash” as a major contributor to their startup failure. Almost 20% say they went under due to pricing or cost issues.

Calculating and understanding your cost of goods sold (COGS) will help you to better understand your small business cash flow, and set you up for long-term success.

In this post, we’ll explain what the cost of goods sold is, how to calculate it, and how to report it during tax season.

What is cost of goods sold (COGS)?

Your cost of goods sold includes the direct costs associated with the production of the products your small business sells.

Your direct costs are most often the inventory purchased to make or sell products to customers. But there are other purchased items and indirect costs (like overhead costs) that can be included in your COGS calculations, which we’ll get into shortly.

What counts under COGS?

If you own a donut franchise, for example, you’d include the following in your COGS calculation:

• The direct inventory cost of manufacturing the donuts, including the regular purchase of baking soda, flour, sugar, and yeast.
• Any tools you need to operate while making a donut — from pots and pans to fryers and stand mixers.
• Indirect costs like employee wages to make the donuts, utility bills for things like water (if it’s in the recipe), or rent paid for a manufacturing facility.

What’s not included in COGS

If you are a small business owner who doesn’t manufacture your own products, your cost of goods sold typically would not factor in your indirect overhead costs (or operating expenses) incurred to run your business.

For example, when you purchase inventory from other vendors for resale, your indirect costs might include the monthly cost to rent your storefront or to keep the lights on.

Likewise, you do not need to include anything in your COGS calculations that goes into your cost of revenue, meaning the total amount you invest to sell products to customers. These costs include line items like your marketing and product distribution expenditures.

It’s always best to check with an accountant or tax expert to learn what direct and indirect costs should or shouldn’t be included in your COGS calculation.

Why service-based small businesses don’t use COGS

When doing COGS calculations, business owners must itemize the inventory they purchased (within a set time period) to manufacture or sell their products to customers.

That’s why most service-based businesses, like freelancers, consultants, and service-based software do not typically use COGS when preparing financial statements.

Of course, there are some exceptions, like a hairdresser who might sell items in-store such as shampoo, hairstyling products, and anything else that is part of their inventory as a good to be sold.

Why small businesses should care about COGS

From a tax perspective, you need to know your cost of goods sold — broken down into different line items on your business income tax form — so you can report it to the government. We’ll get into income tax reporting for COGS later in this post.

From an accounting and finance perspective, small business owners must also understand your break-even point and determine the lowest price you can set for your products to keep your business running smoothly.

COGS plays a crucial role in determining those factors, as well as in managing cash flow and finding cost savings.

For help with calculating your break-even point, read: “What is break-even analysis.” You might also want to learn more about cash flow forecasting for small businesses, and understand how to avoid cash flow problems.

How to calculate cost of goods sold

To calculate your cost of goods sold, you first need to understand the total amount of inventory and other relevant costs (if you’re a manufacturer) you regularly spend for the products you sell on a monthly, quarterly, and annual basis.

The time period for calculating COGS depends on the type of business you run and how you do your accounting.

Likewise, there are different ways to do the COGS calculations, including:

• First in, first out (FIFO)
• Last in, first out (LIFO)
• Average cost
• Special ID method

It’s crucial to have all of this information ready for your accountant — or for a tax professional to help you understand what you need to do if you manage your own books.

COGS calculation formula

For each relevant COGS reporting time period, start with the total value of your beginning inventory (i.e. the materials you already have on-hand) before you make any new purchases. Then, add on the total value of any new materials you purchased over the same time period.

For simplicity, let’s say you want to measure COGS over one month, and your total value for existing inventory is 5,000 units at a cost of $1.00 each. Your beginning inventory is, therefore, worth $5,000.

Next, you buy an additional 5,000 units at the same cost. You now have $10,000 worth of inventory ($5,000 + $5,000) to sell.

Over the course of that month, you sell 7,500 units. At the end of the month, you’re now left with 2,500 units in your inventory (at a cost of $1.00 each = $2,500).

Here’s the formula you’d use to calculate your cost of goods sold for the month:

Beginning inventory = $5,000

• Purchases = $5,000

– Ending inventory = $2,500

________________________

Cost of goods sold = $7,500 for one month

As your business grows, and as you start to measure your cost of goods sold over longer periods, you might use more sophisticated ways to calculate these numbers.

Let’s assume you’re looking at your COGS on a quarterly basis, and the cost to purchase your inventory changes each month. The first month, the cost per unit is $1.00, the second month it goes up to $1.50, and in the third month, it costs $1.25 per unit.

First in, First Out (FIFO) method

This COGS accounting method assumes you’ll sell the inventory worth $1.00 per unit first, before selling items sold in later months. Let’s assume that over the 2nd quarter of 2022, you sell a total of 325 units. In April, you had 100 units left in stock (worth $1.00 each) and you sold all of them.

In May, you purchased an additional 200 units at $1.50 each and sold all of them. Finally, you purchased another 200 in June and sold only 25.

Let’s do the COGS calculation, starting with the cost per unit sold each month.

• April = $1.00 x 100 units = $100
• May = $1.50 x 200 units = $300
• June = $2.00 x 200 units = $400

Your cost per goods sold is, therefore:

$100 (for the existing inventory in April)
+ Purchases in May and June worth $700 ($300 + $400)

– Ending inventory of 175 units (@ $2.00 each) = $350

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$450 is your quarterly FIFO COGS ($100 + $700 – $350)

Last in, Last Out (LIFO) method

In this scenario, you calculate COGS by using the value of your inventory in the last month of the quarter first.

Some businesses use this method to get a tax break when their cost per unit goes up significantly over a set time period.

Using the numbers illustrated above in the FIFO COGS calculation, you’d use the value of your goods purchased in June as your starting point. Let’s say you sold a total of 300 units in the quarter. You’d take the value of the 200 units sold in June (at $400), add 100 units at the May rate (100 x $1.50 = $150), and calculate your COGS like this:

$400 (for all units bought in June)
+ $400 (for units purchased in April and May)

– $250 (inventory left from April and May = 100 @ $1.50 + 100 @ $1.00)

____________________

$550 is your quarterly LIFO COGS ($400 + $400 – $250)

Keep in mind that using the LIFO method for COGS will eat into your profits. Therefore, you need to weigh the value of reporting losses for tax breaks versus reporting higher revenue, which might raise concerns with your bank when you need financing, or if you have any business investors or shareholders (as your business grows).

Average cost method

This is a simple COGS method that uses the average cost of the inventory purchased over a three-month or annual reporting period in the COGS calculation.

Using the example above, you’d add all three unit prices up and apply the average cost against all units sold during that time period. You may want to start out using the average cost method to manage cash flow, especially if you don’t manufacture your own products.

Special ID method

This COGS method is used when you sell multiple products that vary in manufacturing costs over a set time period. For example, an automobile manufacturer will sell different car models with different product identification numbers. In this instance, it would be wise to work with an accountant to properly calculate your COGS.

What do I need to know about COGS and taxes?

Regardless of whether you calculate your COGS monthly or quarterly, you’ll need to do so during tax season. Your COGS calculations must be completed in Part III (Schedule C) of your small business income tax statement.

You can use the cost of goods sold worksheet on lines 35 to 42 of page two.

This content should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation. Check the IRS website for up-to-date instructions and requirements.

Let’s take a closer look at each of the line items that go into the COGS calculation.

Line 35: Inventory at the beginning of the year

If you’re an online or physical retailer, and simply re-sell the inventory you purchase from someone else, the amount on this line is the cost of the merchandise you had on hand at the beginning of the year.

It’s different if you manufacture your own products. The amount on this line would be the cost of any items you produced, plus the cost of the supplies you purchased in the reporting tax year and still have on hand to make products you’ll sell in the future.

Note: If there is any difference between the previous year’s ending inventory and this year’s beginning inventory, you will need to explain why.

Line 36: Purchases less cost of items withdrawn for personal use

For re-sellers, the amount you input on this line should be the inventory you bought during the tax year.

If you manufacture your own items to sell, the amount should include the materials and parts you purchased during the year from vendors (including any discounts they gave you).

Always be sure to remove the cost of any items you returned, as well as any items you pulled out of your inventory for your own personal use.

Line 37: Cost of labor (minus your own paid labor)

Your cost of labor consists of three elements:

1. Direct labor: Wages you paid to employees who made the products to be sold.
2. Indirect labor: What you paid to employees who performed general factory functions, such as a foreman, and whose work does not have a direct connection with the making of the product.
3. Other labor: Wages for selling or administrative personnel.

If you run a manufacturing business, the labor costs you input on line 37 for COGS should be relevant to each product produced during the period. A tax account should be able to help you identify which costs to use in your COGS calculation.

Re-sellers won’t likely have many labor costs, and you must not include your own paid labor (as the business owner) in your cost of goods sold.

Line 38: Materials and supplies

The number inputted on this line for COGS should include the cost of the items that are separate from the main materials used in the manufacturing of your product — but are still an important part of producing it.

For example, these materials might include glue or buttons that a fashion retailer sews onto their garments.

Line 39: Other costs

Additional costs can be added to your cost of goods sold, depending on the type of business your run.

Manufacturers can use this line to record any additional costs of creating your product — such as packaging and shipping costs to bring in supplies and materials — as well as the overhead costs for running your factory (but not the costs to sell or distribute products).

Line 40: Cost of goods available for sale

On this line, you should add up the amounts on lines 35 through 39 to get the total cost of goods available for sale.

Line 41: Inventory at end of the year

On this line, you should include the value of the items you have in your inventory that have not yet been sold as of year-end.

Like most businesses, you may need to do a physical inventory count of what you have in stock on December 31, and determine the cost to produce the items in that count.

When placing a value on your end-of-year inventory, be sure to use the cost to produce the items in your COGS calculation and not the price you charged customers for these items.

Now you have everything you need to calculate your cost of goods sold for the tax year. On line 42, subtract the amount on line 41 from line 40. You’ll input this final number on line 4 of page 1 of Schedule C – Cost of Goods Sold.

For additional help when completing your small business taxes, read: How to organize your financial statements to make tax season smooth sailing.

Planning for long-term growth with COGS

Once you calculate your cost of goods sold, you’ll gain a better understanding of your monthly, quarterly, and annual cash flow.

Your COGS calculations can also help you to price your products accordingly, complete your business income taxes, and plan for the long-term growth and success of your small business.

Keep in mind, the above content provides a general explanation, and how you calculate COGS will depend on many factors. For example, manufacturing businesses will have more sophisticated requirements for tracking inventory and calculating the cost of goods sold.

Always consult an accountant or tax professional for specific COGS reporting or tax requirements for your small business.

This article includes content originally published on the GoDaddy Blog by Chris Peden.