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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 of your success. Without it, you cannot know how much revenue, expenses, and overall profit (or loss) your small business had for a specific time frame. 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. For example, 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 the cost of goods sold?
The definition of the cost of goods sold is relatively simple and easy to understand. It is the total direct costs that your small business incurs to produce the goods you sell. Typical direct costs include parts, raw materials, labor, and shipping. Let us use a cabinet-making company to explain this in greater detail. The business 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 for 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 your income statement’s “operating expenses” category. A business accountant can ensure that your expenses are included in the correct categories.
What is the cost of goods sold formula?
You do not need to be an accountant or a mathematician to calculate the cost of goods sold. However, if your business income statement is up-to-date and accurate, you must add your beginning inventory with your purchases and subtract your ending inventory. COGS can be calculated for a specific period: 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 you are evaluating. As the name states, your ending inventory is the number of unsold goods.
Cost of goods sold example.
Let us assume that you want to calculate your COGS for the year’s first quarter. 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. Therefore, 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 must 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 must 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 ensure you complete the proper IRS form(s).
Including COGS in your business tax return presents you with an excellent benefit. It can 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.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.