Businesses that sell products need to know how to calculate their cost of goods sold (COGS). It can help ensure that your goods are priced accordingly, avoid overspending on production, and enable you to calculate your net profit. The SBA EIDL program and other business loans also require businesses to report their COGS. In this article, we will discuss what it is, why it's important, and how to calculate it.
What Is the Cost of Goods Sold (COGS)?
The cost of goods sold (COGS) is the direct cost associated with the production of goods sold by a company. Generally, COGS includes the cost of labor, material, and utilities used to directly create the goods. It normally does not include indirect costs such as distribution, overhead, and sales & marketing.
Online businesses that build and sell products completely online, such as on Etsy or eBay, can still claim the raw materials used to create their product and the shipping costs of those raw materials as COGS. The IRS allows companies to deduct the COGS from their taxable income, thus lowering their tax burden.
Why Is COGS An Important Calculation?
Calculating the COGS is important for many reasons. First off, a company needs to know its COGS in order to calculate its gross profit. The gross profit margin is a company's profit after the COGS are deducted from total revenue and is used to measure the effectiveness of a company in managing its production costs. The higher the COGS, the lower the gross profit (and net profit) of the company. While there are some tax benefits to having lower net profits, businesses try to keep COGS low.
Another reason the COGS calculation is important is that many business loans, such as the SBA's Economic Injury Disaster Loan (EIDL), requires you to report your COGS. The SBA uses your COGS to determine your potential EIDL loan amount. Your potential loan amount is determined by taking your 2019 revenue, subtracting your COGS (which gives you your gross profit), and multiplying it by two. You can also use our EIDL Loan calculator on your Skip dashboard, or sign up for free here.
What Are Some Examples of COGS?
The generally accepted accounting principles (GAAP) do not give clear guidance on the definition of COGS, which makes pinpointing the COGS for some industries difficult. To reiterate, the COGS refer to the expense that a business incurs to produce a physical product, or purchase for resale. Here are some common examples of COGS.
- Raw materials such as flour, paper, sugar, wire, wood, etc.
- Goods purchased for re-sale such as wholesale products.
- Labor directly related to the production of the goods.
- Overhead costs directly related to the production of goods, such as utilities.
- Storage costs to house the physical products.
Which Businesses Do Not Have COGS?
According to the IRS, businesses that manufacture goods or purchase and re-sell products "generally must value inventory at the beginning and end of each tax year to determine your cost of goods sold." Furthermore, the IRS says "You do not have to figure the cost of goods sold if the sale of merchandise is not an income-producing factor for your business."
In other words, businesses need to have inventory in order to calculate COGS. Generally speaking, if you do not have a physical inventory, you do not have expenses that qualify as COGS. Doctors, lawyers, consultants, and real estate appraisers are common examples of professions that do not typically have COGS.
Are Software and SaaS Companies Exceptions to the COGS Rule?
The easy answer is yes; the exception to the physical inventory requirement is the software as a service (SaaS) industry. Despite the IRS' definition, many leaders in the SaaS industry deem certain expenses as COGS because they are necessary to the sustainability of the business, much like physical products are for other companies. Without incurring certain costs, Saas companies would not be able to produce their product.
Due to the absence of clarity in the GAAP regarding COGS, the specific items considered COGS can vary from business to business. Generally, expenses such as website hosting, customer support labor, third-party software, and other labor costs associated with the creation and maintenance of the software product are included in the COGS. Speak with your accountant or tax professional for specific guidance if you have a SaaS company.
How Do You Calculate Your COGS?
For businesses with traditional inventory, there are direct costs and indirect costs that you need to factor in. Direct costs include raw materials, labor, and other goods required to produce the product. Indirect costs include the facility, equipment, utilities, and other labor required to produce the product.
To calculate your COGS, begin with your current or starting inventory. Determine the cost of your current inventory, add to it the cost of additional purchases you make during the period (month, quarter, year), then subtract the cost of the remaining inventory at the end of the period to get your COGS. Below is an example.
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Disclaimer: This article is meant to be used for illustration purposes only. This is not intended to provide tax or accounting advice.