Cost of Goods Sold: A How-To for Small Manufacturers
Why is Knowing Cost of Goods Sold Important?
Cost of goods sold (COGS) is another financial metric that can be difficult to wrap your head around. But there's no need to get swamped by all the figures and financial jargon.
It may be a pain at first, but stick at it. When everything clicks into place, your business becomes much smarter by all accounts.
Get on top of this important metric, and you can find ways to make more money — without gaining any more customers.
That’s how powerful good accounting practices are. It is why big enterprises spend colossal amounts on accountants and legal advisers.
Your small manufacturing business doesn’t have to get left behind. Everything is under your control. We’re here to show you there is a quick and easy solution designed for small businesses.
Cost of goods sold is one of the vital cogs in your manufacturing business. It may be tempting to ignore or overlook it — this is not only bad practice, but bad for your margins.
What is Cost of Goods Sold?
In short, cost of goods sold is how much it costs your business to sell inventory over a given period of time. This could be monthly, quarterly, or yearly. You could calculate COGS every month, and also do a quarterly review to make sure everything lines up. Other businesses may only do this quarterly.
It's up to each business owner to figure out what is best for their needs. In any case, the basic principles stay the same.
COGS is a method of giving a real-world valuation to your inventory. Your material and labor expenses could fluctuate from month to month. It pays to keep up with the price of getting your goods to market.
COGS tells you how much you spend to turn your raw materials into sold products.
It is useful in two main ways:
It gives you important information about your business’ expenditure; and
It is necessary to produce accurate tax statements, which shows your taxable income.
In the US, small businesses are routinely subject to tax audits. The IRS makes sure they are reporting their income accurately. This means that COGS is serious business.
Calculating cost of goods sold is vital to know your taxable income. Other metrics like leftover stock can also be taxable, so you need be on top of everything.
The accurate calculation and reporting of COGS is necessary under GAAP (Generally Accepted Accounting Principles).
We will go through how to calculate cost of goods sold from a manufacturing perspective.
How to Calculate Cost of Goods Sold
First you need to work out all your income and outgoings for your business. Separate your expenses because COGS should only include certain outgoings.
Income Included in COGS
The sale income from manufactured goods; and
The sale income from any resold goods.
Income Not Included in COGS
Income from any other services that do not include selling goods.
Expenses Included in COGS
Raw materials; and
Direct labor costs.
Expenses Not Included in COGS
SG&A (Sales, General, and Admin costs), including rent, utilities, and e-commerce fees; and
Cost of goods sold can be calculated in the following manner:
Choose the time period you want to measure. Then find out the value of your inventory at the beginning and end of the chosen period. Don't forget to include any inventory added in this time. Include the direct labor cost as part of the inventory valuation. The formula looks like this:
Cost of Goods Sold = (Beginning Inventory + Additional Inventory) – Ending Inventory
This is how to calculate cost of goods sold if you are doing periodic inventory. A perpetual inventory system requires you to make stock adjustments for each sale. That means you can calculate COGS for each sale. Doing this manually is way more labor-intensive but gives you more information and accuracy.
Once you have your COGS value, you can use it to work out your gross profit.
Gross Profit = Revenue From Sold Goods – COGS
Of course, this doesn’t take into account all your losses (and maybe not all your income). You need to work out other forms of revenue and expenses for your net profit.
So how to value your inventory? This depends on the inventory costing method you use. Each has advantages and disadvantages. The three main options are:
Choosing a Costing Method for COGS: FIFO, LIFO, or Average Cost
First In, First Out (FIFO)
Many large manufacturers regard this as the “theoretically correct” inventory valuation method. It asserts that the first materials and stock to come into inventory, will be the first out when sold.
Advantage: This gives you a more accurate valuation of your current inventory. This is because all present inventory best represents the cost of the inventory most recently purchased.
Disadvantage: The COGS reflects older historical costs. That means the gross profit calculation may not reflect the actual figure.
Last In, First Out (LIFO)
This is selling the most recent additions to your inventory first. If the cost of raw materials increases, the company will sell the higher-cost goods first. This means a business can report higher deductions for tax purposes.
Advantage: It can be good for a company’s cash flow as it records less taxable income.
Disadvantage: The last items added to inventory are usually the most expensive. This can inflate your COGS.
Measured Average Cost (MAC)
As the name suggests, this method takes your average unit cost and applies it to all goods sold in that period. To calculate it, simply multiply average purchase price by number of units sold.
Advantage: It gives a more realistic reflection of your COGS. Using averages mitigates for changes in market prices and other changeable factors.
Disadvantage: The IRS and other tax authorities may still require you to report your inventory costs using another method (e.g. LIFO).
Each of the above accounting methods are accepted under GAAP.
The conclusion — using MAC is the best of both worlds. This has been the most common practice for small businesses as it is the easiest and most useful method for their needs.
Averaging out costs gives you the whole picture. It does not allow COGS to change significantly due to market fluctuations.
This method has stuck around for a reason – it works.
Calculating Cost of Goods Sold: Analysis with an Example
Say you have a handmade jewelry business. You start with $1000 of inventory. This includes $800 in raw materials and $200 in direct labor (manufacturing) costs.
You sell $600 worth of jewelry (leaving $400 remaining in stock).
To keep up with this demand, you manufacture $500 more jewelry, including $100 in labor costs.
You then sell $350 worth of jewelry more.
Over this period, the cost of goods sold formula will look like this:
COGS (Monthly) = (1000 + 500) - (550) = $950
Now you know the cost of goods sold, you can decide if you have a reasonable markup for your products. For handmade jewelry, this could be at least two times the material and labor cost. So, if the cost-price $1,500 was sold with a x2 markup, then the revenue would be $3,000.
You can then use this to calculate gross profit:
Gross Profit = 3,000 – 950 = $2,050
Of course, it’s possible to calculate cost of goods sold without including direct labor costs. The GAAP is to include direct labor cost.
Doing this, you can work out the ratio of labor to manufactured goods on a larger scale. This is useful to consider when analyzing your workshop’s overall efficiency.
Cost of Goods Sold Problems with Direct Materials
Let’s break this down further by showing the calculation of raw materials expenses per unit as part of COGS.
Say you’ve started a small hobby business selling handmade scented candles. You purchase the necessary equipment, raw materials, and supplies. In order to calculate COGS, you need to know the value of raw materials that goes into one unit.
Let’s go over the raw materials cost, and how it relates to COGS.
The raw materials are:
A glass jar;
A warning label; and
A brand label.
You buy the primary material, wax, at $0.07/oz. You decide for a good size each candle will use 6oz. of wax.
Therefore: 0.07 * 6 = 0.42. That’s $0.42 for each candle.
Each candle needs fragrance oil at an amount of 6% of the wax weight.
So, multiply six percent with the total wax weight to find the amount of fragrance oil.
0.06 * 6 = 0.36oz of fragrance oil.
Multiply this by the total price of fragrance oil per ounce ($1.25) and you get $0.45.
Then you add in the cost of the wick ($0.10).
The other materials are a glass jar ($0.50), a warning label ($0.03), and your brand label ($0.50).
Your total raw materials cost per unit is $2.00. This is useful for calculating total manufacturing cost. You sell each candle for the price of $8. So, you have a $6 gross margin per unit sold.
You create a first batch of 30 candles which is worth $60 plus direct labor costs.
In the first two weeks, you sell 25 candles at the standard selling price of $8.
As the first batch is running low you manufacture a further 30. But your supplier costs have gone up and it now costs $3 to make one candle. You then sell a further 15 candles. Using Measured Average Cost, it doesn’t matter which batches are sold, for the calculation to work.
So, the cost of goods sold breakdown for this month would look like this:
In practice you would also add in direct labor costs, depending on wage per hour and the time it took to produce those two batches.
Don’t forget that this is gross profit, and you still need to take into account taxes and other expenses. This makes the calculations even more complicated. But don’t fret — there is a way to do this automatically.
How to Automatically Calculate COGS with Katana
Tired of the chore of going through your all your books to painstakingly calculate COGS? Maybe some things aren’t so clear a month later — the note you scribbled down for stock losses might have been damaged or lost.
You can have automatic financial overviews which include COGS with Katana – The Smart Workshop Software.
Katana is always working behind the scenes, so it does perpetual inventory without a problem. This means your inventory is always up to date down to the last item.
You can see COGS as soon as an order is done. You get a full report with everything including direct materials and labor. You can immediately see the taxes, profit, and COGS for that order when you go to the “Done” screen.
You can instantly switch between the COGS for last month and the current month. You also have the choice to create custom time periods, depending on your needs. Do this by opening the drop-down menu below “Picked Date” (below).
You always know how much you earn and how much you spend for every day, every month, and every year.
Katana does the hard work of keeping up-to-date with all inventory changes.
In short, it does the boring stuff — so you don’t have to.
Of course, you can control everything manually too. It’s completely up to you. Spend as much or as little time as you want analyzing your inventory and financial statements. Katana has everything ready at the touch of a button.
Most accounting software packages are made for qualified accountants. Katana is made for the independent maker. Large businesses set aside huge chunks of their budget to hire an accounting team — it makes sense for their needs. It doesn’t matter to the CEOs of large companies how easy or difficult calculating financial statements is.
Katana brings this power into your hands. We know not everyone is a trained accountant. That’s why this Smart Workshop Software is just as easy for novices and financial experts alike.
Cost of Goods Sold Affects Your Margins
Know how well your company can convert inventory into profits.
Katana makes this much easier for you. You don’t need to remember how to calculate cost of goods sold with Katana — it does the laborious stuff for you. It’s your job to understand the importance of cost of goods sold, and how it affects your business.
Keeping track of cost of goods sold is essential for tax purposes and profit margins. It is also important for steering your business down the right path in the future.
Nothing is static in business. Will your materials cost suddenly increase? Do you have the right cash flow to pay your staff a good wage?
Maybe you are paying too much to manufacture goods, and your margins are suffering. With COGS you can identify this early and plan a course of action.
Understanding COGS lets you make more informed decisions for all these issues and more.
When it comes to the health of your business, the more information, the better.
That’s why you can keep track of inventory in real-time without doing a single calculation.
Katana shows you COGS, tax, and profit as soon as you click the order as ‘Done’. There is no need for confusion.
You have the power to manage your finances as you see fit. You can choose to include labor costs in COGS or leave it out. It is down to your particular business needs.
Try Katana for free and spend less of your business’ time being bogged down by COGS.