Tracking and managing your cost of goods sold is essential for maintaining financial stability, especially in turbulent times. With the global Economic Policy Uncertainty (EPU) Index reaching record heights due to trade and tariff fears—up to 39% higher than its peak during the COVID-19 pandemic—it’s more important than ever for small businesses to optimize their production costs.
But even in more stable conditions, knowing how to calculate cost of goods sold, why it matters so much for your business performance, and what steps you can take to improve the metric over time will prove invaluable.
What Is Cost of Goods Sold (COGS)?
The cost of goods sold (COGS) is an accounting metric that contains all of the expenses directly related to making your products physically ready for sale. That generally includes costs like:
- Raw materials: These are the various components you assemble or refine to create your final product.
- Direct labor: This refers to the wages and benefits you pay to workers responsible for production.
- Manufacturing overhead: This includes overhead tied to the production process, such as factory rent and utilities or equipment maintenance.
On the profit and loss (P&L) statement, COGS sits below net revenue, from which you subtract it to calculate gross profit. It also comes before—and excludes—operating expenses, like administrative wages and marketing costs.
For example, say you run a furniture business. Your COGS would include your costs for wood and upholstery, as well as wages paid to workers building the furniture. However, it wouldn’t include the travel expenses you incurred to go to a recent trade show.
Pro Tip: COGS is closely connected to core accrual accounting concepts. That includes revenue recognition standards and the matching principle, which states you should record expenses in the same period as the revenue they help generate.
How To Calculate Cost of Goods Sold
Under the accrual basis of accounting, the cost of goods sold calculation involves backing into an amount through your inventory levels.
Here’s the basic COGS formula:
COGS = Beginning Inventory + Current Period Purchases – Ending Inventory
For example, say your apparel business finished June with an inventory balance of $50,000. During July, you spent $15,000 on clothing materials and sewing wages. After accounting for apparel sold, you end July with an inventory balance of $45,000.
Here’s how you’d use that information to calculate your cost of goods sold for July:
COGS = $50,000 + $15,000 – $45,000 = $20,000
Looking at this from another angle, your COGS for a given period equals the value of any newly acquired inventory netted with the overall change in your inventory levels. In this case, you produced $15,000 of inventory but ended the month with $5,000 less on hand, meaning you must have sold $20,000 worth of products.
Pro Tip: Under the cash basis of accounting, you would calculate COGS simply by adding up the production costs you incurred during the period. However, that would only be $15,000 here, when we know you actually sold $20,000 worth of goods. This shows how the accrual basis better matches costs with the revenues they help generate.
Common Mistakes When Calculating COGS
Calculating COGS can be one of the more challenging aspects of accounting for small businesses, especially as your inventory levels and sales volume increase. Here are some of the most common mistakes to watch out for:
- Poor inventory management: If your inventory records are inaccurate, your COGS calculations will be too. Avoid managing inventory with spreadsheets and other manual tools, which are time-intensive and prone to error. Instead, consider using inventory tracking software that integrates with your accounting system. Supplement it with physical counts at regular intervals.
- Misclassifying expenses: Determining what does and doesn’t count toward COGS can be surprisingly tricky, especially when you have manufacturing overhead costs to allocate. Because it can also be time-consuming, it’s often worth hiring an accounting expert who can manage things for you.
- Overlooking carrying costs: Don’t forget to account for the costs of storing your unsold inventory for extended periods, especially if your products are perishable. For example, spoilage, shrinkage and obsolescence can all distort your inventory levels if you ignore them.
Why COGS Matters to Business Performance
COGS is one of the most important metrics for business leaders to analyze, providing financial insights that should inform many of your strategic decisions. This is because it ignores everything except the costs necessary to create and sell your products.
As a result, it’s an excellent tool for assessing how efficiently your business turns inputs into profit—the core of your operation—especially when you consider it in relation to your gross revenues.
As mentioned previously, subtracting COGS from revenue is how you calculate your gross profit: a metric that captures how much of a period’s revenues you retain after covering the direct costs to generate them.
To make this aspect of your finances easier to analyze, it’s often helpful to look at it through the lens of your gross margin:
Gross Margin = (Revenue – COGS) ÷ Revenue
This effectively converts your gross profit into a percentage, making it much easier to compare your results to those from other periods or other companies.
For example, if your 2024 revenues were $500,000 and your 2024 COGS was $175,000, your gross margin for the year would be:
Gross Margin = ($500,000 – $175,00) ÷ $500,000 = 65%
This tells you that for every dollar of revenue you generate, you keep $0.65 after covering the direct costs necessary to make that sale. That knowledge should play a pivotal role in decisions regarding issues like pricing, budgeting and cash flow.
For instance, if gross margin was 75% in 2023, you might deduce that inflation has steadily increased your COGS and eroded your profitability. It might be time to raise your prices to get gross profits back on track.
The Importance of Benchmarking COGS
It can be surprisingly tricky to determine whether your COGS is at a healthy level in a vacuum. Instead, it’s often more effective to benchmark your costs against those of other businesses in your industry.
While you can compare gross amounts, differences in company size make it tough to derive any meaning. As a result, the best approach is usually to consider gross profit margins, which are expressed as percentages of revenue, leveling the playing field.
For example, say you find that the average gross profit margin of your five closest competitors is 50%, with most ranging from 45% to 55%. However, your gross profit margin is sitting stable at 40%.
That would indicate you have significant room to improve, such as by revisiting your pricing strategy or reducing your COGS.
Monitor Your Inventory Turnover Ratio
Another valuable lens into the health of your COGS and operational efficiency is to examine your inventory turnover ratio. This measures how many times you sold and replaced your inventory during a given period.
Here’s how to calculate your inventory turnover ratio:
Inventory Turnover Ratio = COGS ÷ Average Inventory
And here’s the average inventory formula:
Average Inventory = (Beginning Inventory + Ending Inventory) ÷ 2
Say you started November with $10,000 in inventory and ended with $15,000 worth of goods on hand. Your average inventory would be:
Average Inventory = ($10,000 + $15,000) ÷ 2 = $12,500
If your COGS for November was $50,000, you’d have an inventory turnover ratio of:
Inventory Turnover Ratio = $50,000 ÷ $12,500 = 4
This can be especially beneficial in combination with your gross profit margin, adding critical context to your financial performance.
Say you and your closest competitor both have a 30% gross profit margin, but their inventory turnover ratio for November was 12, while yours was only 4. Despite your similar margins, they’re selling inventory three times faster than you.
That should prompt you to investigate, as it has significant implications for your cash flows. Depending on what you discover, you may decide to take action to close the gap, such as by expanding your sales department or tightening your inventory management.
How To Improve COGS Over Time
If you’ve determined there’s room to improve your COGS, here are some of the most effective strategies you can use to reduce your costs over time:
- Renegotiate supplier contracts: If you’ve been doing business with a supplier for several months or more, consider revisiting the terms of your contract, especially if you’ve developed a stronger relationship. For example, you might ask for better volume discounts or loyalty incentives.
- Improve demand forecasting: Inaccurate estimates of future demand can cause you to produce or acquire more inventory than you need, inflating COGS and carrying costs. Consider investing in better forecasting tools that can analyze historical data, seasonality and market trends to predict demand.
- Automate inventory tracking: Manual inventory tracking is slow and prone to errors, making it harder to monitor inventory levels and make purchases to align them with demand. Consider investing in an automated inventory management system that integrates with your accounting software.
- Reevaluate production strategies: Whether you outsource your production or manage it in-house, consider whether the alternative approach could reduce your COGS, especially if you’ve been using the same approach for a while. Some aspects of production may now be cheaper to outsource or vice versa.
Get Expert COGS Support With Paro
Tracking and optimizing COGS is essential for maintaining financial stability, especially during periods of economic uncertainty. However, it requires strong tracking systems, deep accounting knowledge and significant strategic expertise, especially as your business grows in size and complexity.
Managing it on top of all your other responsibilities as a business owner can be overwhelming, and hiring a full-time accounting team to do it for you can be prohibitively expensive.
That’s where Paro comes in. Whether you need help adopting new inventory management software or identifying new ways to reduce your COGS over time, we’ll connect you with a fractional accountant who can provide on-demand support.
