Understanding the Cost of Goods Sold

Are you confused about cost of goods sold? You aren’t the first. While the idea is simple, it can become slippery as you learn more about it. How are the cost of goods sold calculated? And why does it even matter for a business?

What is Cost of Goods Sold (COGS)?

Cost of goods sold (COGS) measures the cost that was paid to acquire a good that is later sold. Note that this reflects the price initially paid, not the cost of replacing the item now. This means the COGS for a specific item does not change over time, but the same product bought at different times might have different COGS values.

COGS is relevant for both manufacturing businesses and merchandising businesses. In a manufacturing business, COGS is the combined cost of all the raw materials that go into an item that is sold. For a merchandising business, COGS is simply the amount you paid for the items you sell in your store.

Why Does COGS Matter for Your Business?

For any merchandising or manufacturing business, there are lots of products coming and going at any given time. Prices change, expenses go up and down, and items go in-and-out of season. It is easy for an overworked business owner to lose track of profit margins for each item in their stock. By tracking COGS, you can make sure each item you sell still nets an acceptable profit.

COGS is also relevant for inventory management. If your COGS per month is $10,000 and you maintain an inventory of about $10,000, that means you have a month’s worth of merchandise. If your inventory was under $5,000, you might be vulnerable to a supply shock, while a stockpile of $50,000 or $100,000 means you might be overstocking. 

COGS and Accounting

COGS is a helpful concept for managing inventory, but the term originates from accounting. Properly balancing your books requires tracking every dollar that enters or leaves your business. COGS is typically calculated by taking the goods in inventory at the start of a period, adding the cost of goods bought, and subtracting the cost of goods still in inventory at the end of the period.

Accounting resets at the start of each fiscal period, but inventory can stick around for months or even years. COGS is like the “present you” paying back “past you” for the money spent on buying the good you just sold.

Revenue devoted to covering COGS is treated differently than other cash flows when it comes to taxation. Keeping COGS separate from your other revenues and expenses will simplify your financials in the future.

Getting the COGS Turning

COGS is a simple but important concept in both accounting and business. Every business should diligently track this value to ensure you are managing your inventory and pricing. Armed with this information, you will be better positioned to execute your strategy and expand your e-commerce business.

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Carlos Alvarez

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