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What is Cost of Goods Sold? (COGS)

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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.

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)?

retail store

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

________________________________

$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.

Cogs taxes calculation

Cogs taxes calculation

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

charts showing growth

charts showing growth

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.



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Finance & Accounting

4 tips to find the funding that fits your business

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The facts are clear: Startups are finding funding increasingly difficult to secure, and even unicorns appear cornered, with many lacking both capital and a clear exit.

But equity rounds aren’t the only way for a company to raise money — alternative and other non-dilutive financing options are often overlooked. Taking on debt might be the right solution when you’re focused on growth and can see clear ROI from the capital you deploy.

Not all capital providers are equal, so seeking financing isn’t just about securing capital. It’s a matter of finding the right source of funding that matches both your business and your roadmap.

Here are four things you should consider:

Does this match my needs?

It’s easy to take for granted, but securing financing begins with a business plan. Don’t seek funding until you have a clear plan for how you’ll use it. For example, do you need capital to fund growth or for your day-to-day operations? The answer should influence not only the amount of capital you seek, but the type of funding partner you look for as well.

Start with a concrete plan and make sure it aligns with the structure of your financing:

  • Match repayment terms to your expected use of the debt.
  • Balance working capital needs with growth capital needs.

It’s understandable to hope for a one-and-done financing process that sets the next round far down the line, but that may be costlier than you realize in the long run.

Your term of repayment must be long enough so you can deploy the capital and see the returns. If it’s not, you may end up making loan payments with the principal.

Say, for example, you secure funding to enter a new market. You plan to expand your sales team to support the move and develop the cash flow necessary to pay back the loan. The problem here is, the new hire will take months to ramp up.

If there’s not enough delta between when you start ramping up and when you begin repayments, you’ll be paying back the loan before your new salesperson can bring in revenue to allow you to see ROI on the amount you borrowed.

Another issue to keep in mind: If you’re financing operations instead of growth, working capital requirements may reduce the amount you can deploy.

Let’s say you finance your ad spending and plan to deploy $200,000 over the next four months. But payments on the MCA loan you secured to fund that spending will eat into your revenue, and the loan will be further limited by a minimum cash covenant of $100,000. The result? You secured $200,000 in financing but can only deploy half of it.

With $100,000 of your financing kept in a cash account, only half the loan will be used to drive operations, which means you’re not likely to meet your growth target. What’s worse, as you’re only able to deploy half of the loan, your cost of capital is effectively double what you’d planned for.

Is this the right amount for me at this time?

The second consideration is balancing how much capital you need to act on your near-term goals against what you can reasonably expect to secure. If the funding amount you can get is not enough to move the needle, it might not be worth the effort required.

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Banking

Overdraft Protection: What It Is and Different Types

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Overdraft fees can be a major drain on your finances. Some banks charge more than $30 per overdraft and potentially charge that fee multiple times per day if you keep making transactions that overdraw your checking account. If you want to avoid these fees, you can typically opt out of overdraft coverage with your bank. It can be useful, however, to set up overdraft protection instead of opting out so you don’t find yourself unable to pay for something urgent.

What is overdraft protection?

Overdraft protection is a checking account feature that some banks offer as a way to avoid overdraft fees. There are several types of overdraft protection, including overdraft protection transfers, overdraft lines of credit and grace periods to bring your account out of a negative balance. Some other overdraft coverage programs might be a combination of these features.

Before you opt out of overdraft protection altogether — which means your bank will decline any transaction that would result in an overdraft — consider how you might need overdraft coverage in an emergency. For example, maybe you’re using your debit card to pay for gas on a road trip. You need enough fuel to get home but don’t have enough money in your checking account. Instead of dealing with running out of gas, you may want to deal with an overdraft.

How does overdraft protection work?

Here are more details about the main types of overdraft protection that banks tend to provide.

Overdraft protection transfers. When a bank allows you to make an overdraft protection transfer, you can link a savings account, money market account or a second checking account at the same bank to your main checking account. If you overdraft your checking, your bank will take the overdrawn funds from your linked account to cover the cost of the transaction. Many banks allow this service for free, but some banks charge a fee.

Overdraft lines of credit. An overdraft line of credit functions like a credit card — but without the card. If you don’t have enough money in your account to cover a transaction, your bank will tap your overdraft line of credit to cover the remainder of the transaction. Lines of credit often come with steep annual interest rates that are broken up into smaller interest charges that you keep paying until the overdraft is paid back. Be aware that a line of credit could end up being expensive if you use this option to cover your overdrafts.

Grace periods. Some banks offer grace periods, so instead of immediately charging an overdraft fee, the bank will give you some time — typically a day or two — to return to a positive account balance after overdrafting. If you don’t do so within that time frame, your bank will charge you fees on any transactions that overdrafted your account.

Other coverage programs. Some banks are taking a new approach to overdraft protection by offering what’s basically a free line of credit with a longer grace period for customers to bring their account to a positive balance. One example, Chime’s SpotMe® program, allows customers to overdraft up to $200 with no fees. The customer’s next deposit is applied to their negative balance, and once the negative balance is repaid, customers can give Chime an optional tip to help keep the service “free.”

Chime says: “Chime is a financial technology company, not a bank. Banking services provided by, and debit card issued by, The Bancorp Bank or Stride Bank, N.A.; Members FDIC. Eligibility requirements and overdraft limits apply. SpotMe won’t cover non-debit card purchases, including ATM withdrawals, ACH transfers, Pay Friends transfers or Chime Checkbook transactions.”

4 ways to avoid overdraft fees

  1. Set up low balance alerts. Many banks offer an alert option so you’ll get a text, email or push notification if your account drops below a certain threshold. These alerts can help you be more mindful about your balance so that you can put more money into your account or spend less to avoid an overdraft.

  2. Opt out of overdraft coverage. If your bank doesn’t offer overdraft protection — or if its only options cost money — you may want to opt out of overdraft coverage, in which case your bank will decline any transactions that would bring your account into the negative. Keep in mind that this option could put you in a sticky situation if you’re in an emergency and can’t make an important purchase because you don’t have overdraft coverage.

  3. Look for a bank that has a more generous overdraft policy. Many banks are reducing or eliminating their overdraft fees, so if overdrafts are an issue for you, do some comparison shopping to see if there are better options available.

  4. Consider getting a prepaid debit card. Prepaid debit cards are similar to gift cards in that you can put a set amount of money on the card, and once you run out, you can load it with more money. The prepaid debit card can’t be overdrawn because there isn’t any additional money to draw from once its balance has been spent.

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Business Ideas

Startup Business Grants: Best Options and Alternative Funding Sources

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Startup business grants can help small businesses grow without debt. But if you want free money to start a company, your time may be better spent elsewhere. Competition for small-business grants is fierce, and many awards require time in business — often at least six months.

Some grants are open to newer businesses or true startups. And even if you don’t qualify now, it can pay to know where to look for future funding. Here are the best grants for small-business startups, plus alternative sources of startup funding to consider.

How Much Do You Need?

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Government startup business grants and resources

Some government programs offer direct funding to startups looking for business grants, but those that don’t may point you in the right direction or help with applications:

Grants.gov. Government agencies routinely post new grant opportunities on this centralized database. If you see an opportunity relevant to your business idea, you can check if startups are eligible. Many of these grants deal with scientific or pharmaceutical research, though, so they may not be relevant to Main Street businesses.

Local governments. Lots of federal grants award funding to other governments, like states or cities, or to nonprofit economic development organizations. Those entities then offer grants to local businesses. Plugging into your local startup ecosystem can help you stay on top of these opportunities.

Small Business Development Centers. These resource centers funded by the Small Business Administration offer business coaching, education, technical support and networking opportunities. They may also be able to help you apply for small-business grants, develop a business plan and level up your business in other ways.

Minority Business Development Agency Centers. The MBDA, which is part of the U.S. Department of Commerce, operates small-business support centers similar to SBDCs. The MBDA doesn’t give grants to businesses directly, but these centers can connect you with grant organizations, help you prepare applications and secure other types of business financing.

Local startup business grants

Some local business incubators or accelerators offer business grants or pitch competitions with cash prizes. To find these institutions near you, do an online search for “Your City business incubator.”

Even if you don’t see a grant program, sign up for their email newsletter or follow them on social media. Like SBDCs and MBDAs, business incubators often provide business coaching, courses and lectures that can help you develop your business idea.

Startup business grants from companies and nonprofits

Lots of corporations and large nonprofits, like the U.S. Chamber of Commerce, organize grant competitions. Some national opportunities include:

iFundWomen. iFundWomen partners with other corporations to administer business grants. You can fill out a universal application to receive automatic notifications when you’re eligible to apply for a grant.

Amber Grant for Women. WomensNet gives two $10,000 Amber Grants each month and two $25,000 grants annually. Filling out one application makes you eligible for all Amber Grants. To qualify, businesses must be at lesat 50% women-owned and based in the U.S. or Canada.

National Association for the Self-Employed. Join NASE, and you can apply for quarterly Growth Grant opportunities. There are no time-in-business requirements for these grants of up to $4,000, but you’ll need to provide details about how you plan to use the grant and how it will help your business grow.

FedEx Small Business Grant Contest. This annual competition awards grants to small-business owners in a variety of industries. You can sign up to receive an email when each application period opens. To be eligible, you’ll need to have been selling your product or service for at least six months. Be mindful, though, that each grant cycle receives thousands of applications.

Fast Break for Small Business. This grant program is funded by LegalZoom, the NBA, WNBA and NBA G League and administered by Accion Opportunity Fund. You can win a $10,000 business grant plus free LegalZoom services. Applications open during the NBA season, which runs from fall to early summer each year.

Alternative funding sources for startups

New businesses likely won’t be able to rely on startup business grants for working capital. The following financing sources may help accelerate your growth or get your startup off the ground:

SBA microloans

SBA microloans offer up to $50,000 to help your business launch or expand. The average microloan is around $13,000, according to the SBA.

The SBA issues microloans through intermediary lenders, usually nonprofit financial institutions and economic development organizations, all of which have different requirements. You can use the SBA’s website to find a lender in your state.

Friends and family

Asking friends and family to invest in your business may seem daunting, but it’s very common. Make sure you define whether each person’s money is a loan and, if so, when and how you’ll pay it back. Put an agreement in writing if possible.

Business credit cards

Business credit cards can help you manage startup expenses while your cash flow is still unsteady. You can qualify for a business credit card with your personal credit score and some general information about your business, like your business name and industry.

You’ll probably need to sign a personal guarantee, though, which is a promise that you’ll pay back the debt if your business can’t.

Crowdfunding

If your business has a dedicated customer base, they can help fund you via crowdfunding. Usually businesses offer something in exchange, like debt notes, equity shares or access to an exclusive event.

There are lots of different crowdfunding platforms that offer different terms, so look around to find the model that works best for you.

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