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Cost of Goods Sold

Your cost of goods sold (COGS) is the costs directly related to purchasing products for resale, manufacturing products to sell, or providing services. Your COGS is documented on your income statement and used to calculate your gross profit margin. You can deduct your COGS from your company’s income as a business expense, which will reduce your tax liability.

What are direct costs?

The direct costs of your goods will vary from business to business, but they can include:

  • the cost to purchase merchandise for resale
  • the cost of raw materials
  • packaging costs
  • the cost of inventory of finished products
  • supplies for production
  • direct labor

Read also: Direct vs. Indirect Expenses – What’s the Difference?

Calculating COGS

Add your beginning inventory to any purchases made during the period. Then, subtract your ending supply.

COGS equals beginning inventory plus purchases minus ending inventory

Example

If you begin the period with $5,000 in inventory, purchase $2,000 in materials during the period, and end the period with $3,000 in stock, your COGS is $4,000.

COGS equals $5,000 plus $2,000 minus $3,000 equals $4,000

What if your costs change during the year?

If your direct costs change during the year, there are three methods for calculating COGS:

  1. first in, first out (FIFO)
  2. last in, first out (LIFO)
  3. Average Cost

Let’s pretend you bought products for resale in three batches during the year and sold 400 units.

  • Batch 1: 100 units at $10 each ($1,000 total)
  • Batch 2: 250 units at $10.50 each ($2,625 total)
  • Bach 3: 150 units at $11 each ($1,650 total)

FIFO

Using the FIFO method, assume that the first products purchased were the first products sold. That means you sold 100 products at $10 each, 250 products at $10.50 each, and 50 products at $11 each. Your COGS would be $4,175.

100 times $10 plus 250 times $10.50 plus 50 times $11 equals $4,175

LIFO

Using the LIFO method, assume that the last products purchased were the first products sold. So, you sold 150 products at $11 each and 250 products at $10.50 each. Your COGS is $4,275.

150 times $11 plus 250 times $10.50 equals $4,275

The IRS doesn’t generally like the LIFO method, but you can apply to use it by filing Form 970. Read also: Does My Inventory Affect My Taxes?

Average Cost

The average cost method uses the average cost of each product. In this example, your average cost is $10.55 per unit.

average cost equals 100 times $10 plus 250 times $10.50 plus 150 times $11 divided by 500 equals $10.55

After you determine your average cost, you can calculate your COGS. In this case, your COGS is $4,220.

400 times 10.55 equals $4,220