Your small business’s income statement, also referred to as a profit and loss (P&L) statement or statement of earnings, is a vital component to your success. Without it, you have no way of knowing how much revenue, expenses and overall profit (or loss) that your small business had for a specific period of time. An income statement is one of three important financial statements that you should have, the other two being a business balance sheet and a business cash-flow sheet.
The three sections of an income statement are revenues, expenses, and profit, and there are subcategories/line items for each. The expenses section needs to include the cost of goods sold (COGS), which this the focus of this Balboa Capital blog post. We explain what COGS is, how to calculate it, and more.
What is cost of goods sold?
The definition of cost of goods sold is relatively simple and easy to understand. It is the total amount of direct costs that your small business incurs in order to produce the goods that you sell. Common direct costs include parts, raw materials, labor, and shipping. Let us use a cabinet making business to explain this in greater detail. The company purchases wood, paint, hardware, and screws to build custom cabinets for kitchens, bathrooms, bedrooms, and garages. Since these items are directly related to the production of custom cabinets, they are included in the cabinet making business’s COGS.
COGS can become tricky when it comes to indirect costs such as marketing, equipment, office rent, sales, and distribution. Indirect costs are excluded from the cost of goods sold because they fall in the “operating expenses” category of your income statement. A business accountant can ensure that your expenses are included in the right categories.
Cost of goods sold formula.
You do not need to be an accountant or a mathematician to calculate cost of goods sold. If your business income statement is up-to-date and accurate, you just need to add your beginning inventory with your purchases and subtract your ending inventory. COGS can be calculated for a specific time period, such as a week, month, quarter or year.
Beginning inventory + purchases – ending inventory = COGS
Your beginning inventory is the amount of business inventory you have remaining from the previous week, month, quarter, or year. Your purchases equal the total direct costs you incurred during the time period you are evaluating. Your ending inventory, like the name states, is the amount of goods that went unsold during the time period.
Cost of goods sold example.
Let us assume that you want to calculate your COGS for the first quarter of the year. On January 1st, your business had a beginning inventory of $35,000. At the end of the first quarter, your purchases totaled $4,800, and your ending inventory was $7,400. Using the standard COGS formula, you will add $35,000 plus $4,800 and subtract $7,400.
$35,000 + $4,800 – $7,400 = $32,400 (COGS for the 1st quarter)
You can then easily calculate your gross profit for the first quarter. For example, if your revenue for the first quarter was $62,000, you just need to subtract your COGS from this number to get your gross profit. In this example, $62,000 (revenue) minus $32,400 (COGS) equals a gross profit of $29,600.
COGS is required in tax returns.
If your small business sells products, you need to include a COGS calculation in your tax return. The specific IRS form that is required will differ based on the legal structure of your business. For example, sole proprietors and LLCs need to use a Schedule C, whereas an S corporation needs to include COGS in Form 1120 or Form 1120-S. Consult with your accountant or tax advisor to make sure that you complete the proper IRS form(s).
Including COGS in your business tax return presents you with a nice benefit. It can actually reduce your taxable income. The more items that are added to your COGS calculation, the lower your tax bill. As mentioned earlier, not all costs qualify for COGS, so do not include any indirect costs that might raise a red flag at the IRS.
We hope this Balboa Capital blog post provided you with the information and insight about COGS that you were looking for. Please note that this is a basic overview of COGS and is not intended to be taken as professional tax preparation advice. Only a business accountant or tax professional can provide you with the recommendations you need relating to COGS and your company’s finances.