A Guide to the Cost of Goods Sold Formula for Business Owners

The cost of goods sold (COGS) formula calculates the total cost of all products your business sells during a business period (year, quarter, etc.) and is important for 3 reasons: 

1. You need it to calculate accurate gross profit on your income statement, which the IRS requires for tax reporting (with exceptions for small businesses with under $29 million in sales). 
2. It helps you manage your business and make key investment decisions by knowing which costs will grow or decrease, and how your profit will grow or decrease with sales volume. 
3. You can demonstrate operational efficiency and investment ROI to outside investors and lenders. 

By running a COGS equation on your business, you can learn where there are areas to save money or grow based on how much it costs you to produce or acquire products. If math isn’t your strong suit, don’t stress; the formula is easy to use and apply to your business. 

The cost of goods sold formula is: 

Beginning Inventory Cost + Current Period Costs of Inventory – Ending Inventory Cost 

Before you begin applying this formula, you need to define the way that makes most sense for your business. The IRS and the Financial Accounting Standards Board share multiple ways to value inventory, like LIFO (last in, first out) and FIFO (first in, first out).   

The cost of goods sold equation works for any of them as long as you’re consistent in tracking your inventory and have an accurate chart of accounts to correctly identify costs that belong to inventory versus other operating or general expenses. 

• Beginning inventory is the total of all costs that went into buying or making your inventory at the start of your reporting/accounting period. This should be the same as the ending inventory from the previous period, and if you are starting a brand new business, this would be zero. 

• Current period costs of inventory include all of your direct and indirect expenses required to produce or acquire inventory that your business will sell. This includes  finished goods you will resell as well as materials, labor, and some other costs to manufacture your own products. It excludes items you remove for sale but don’t return to a vendor or supplier, like products you give away to friends.  

• Ending inventory is the total of all costs that went into buying or making the inventory still on hand at the end of your reporting/accounting period. This will then become the beginning inventory for your next period. 

Imagine you own a T-shirt shop. You buy and resell some T-shirts; you make some of your own to sell; and for the sake of this example, let’s account for only the following facts: 

1. Your tax returns from last year have an ending inventory value of $1,000. 
2. You made the following purchases from vendors over the course of the year:
   T-shirts: 1,000 shirts for $5,000 (including a 10% discount off the list price)
   T-shirts: 700 shirts for $1,400 
   Cotton: $6,380 
   Thread: $1,000
   Sewing needles (assume they don’t last more than a year): $200 
3. Say you have 1 full-time seamstress that costs the company $75,000 each year and 1 other worker fully engaged in the manufacturing process of the shirts you make but not directly sewing the shirts, costing you $50,000 each year. You also have a 2-person sales team that costs you $50,000 each. 
4. You took 10 shirts from inventory (the shirts from 2a) and gave them to your friends for a fun weekend reunion. 
5. You rent a 700-square-foot store including the 100-square-foot room where your seamstress works for $2,100 per month. 
6. At the end of the year, you have $200 in purchased shirts from (2a) and half of the raw materials (cotton, thread, and needles). You sold all of the shirts your seamstress sewed. 

Here’s how you would calculate the COGS formula: 

Component	Notes	Value
Beginning Inventory	#1 above	$1,000
+		+
Current Period Costs of Inventory	Sum of all items in #2 = $13,980    Direct Labor from Seamstress = $75,000    Indirect Labor from other worker = $50,000  (Note that you don’t include the sales people because they are not involved in the manufacturing process)    Remove 10 shirts you gave to friends (you gave them the good shirts from 2a that cost you $5 each) = -$50    Allocate portion of rent to manufacturing (100 square feet is 1/7 of yearly rent) =  $3,600	$142,530
–		–
Ending Inventory	Add remaining shirts ($200) to cost of remaining raw materials (half cotton ($3,190), half thread ($500), half needles ($100))	$3,790
=		=
Cost of Goods Sold	Beginning Inventory + Current Period Costs of Inventory – Ending Inventory	$139,740

 

Not every company is required to do this, and some businesses that think it is needed may discover an exemption. See below for more details. 

You need to use the cost of goods sold formula if the IRS requires your business to keep an inventory, which generally applies to your business if you manufacture and sell something, or if you purchase and then resell it. 

Service businesses like law firms, medical practices, or consulting agencies typically don’t have to use the COGS equation as they don’t manufacture or sell physical products. This applies even if you sell “merch” like logo jackets, coffee mugs, etc. as long as these sales are not material to your business revenue.  

Pro-tip: Even if you’re not required to track COGS, you might still want to track your “cost of services” in a similar way so you get the same insight into your business. This helps you show the ROI in a business expansion plan for future investors and lenders. 

The IRS also doesn’t require businesses to use the COGS formula if they have under $29 million in gross receipts for each of the last 3 years and are not a tax shelter. However, if you’re not a service business, you still need to track COGS as “non-incidental material or supplies,” which means you expense COGS when you “first use or consume” the materials or supplies.  

For example, imagine you manufacture and sell T-shirts, and your fiscal year runs January through December.  

• You used a bunch of cotton, thread, etc. to make a batch of shirts in November (Year 1), and then you sold them in February (Year 2).  

• With the COGS formula, you would account for those shirts’ COGS in Year 2, the year you sold them.  

• Treating them as non-incidental materials or supplies, you would expense the COGS in Year 1 when you “first used” the materials to manufacture them.  

At the start of this article, you read 3 reasons the cost of goods sold is important. Let’s look at each of those in a bit more detail. 

Calculate gross profit on your income statement and fulfill IRS tax requirements 

You subtract COGS from Net Receipts on your income statement to get Gross Profit.  

Sticking with the T-shirt shop example from above, let’s make a few more assumptions: 

• You sell your manufactured shirts for $200 each (you’re a popular luxury brand). 
• You sell your purchased shirts for $100 each. 
• Any returned shirts went back into inventory. 
• Your seamstress made 600 shirts. 

Also, remember that you gave 10 shirts to friends and had 40 shirts in your ending inventory (all of which were ones you bought at $5 each). So, you would have sold the following: 

• 1,650 (out of 1,700) shirts at $100 each 
• 600 shirts at $200 each 

This would give you net receipts of $285,000 and you would subtract COGS ($139,740) from this number to get a gross profit of $145,260. 

For tax filings, sole proprietors or LLC single owners will use form 1040 Schedule C to calculate the cost of goods sold formula (lines 35–42) while Partnerships or Corporations will use form 1125-A. Make sure to consult a tax professional for your business as you will likely have more complex costs, possibly including capitalized costs under section 263A. 

The COGS formula will help you understand how your business can scale with volume so that you know where to invest your money and where to focus your time to keep things running smoothly.  

For example, you can do an easy break-even analysis to see if you have a chance at making a profit. For the T-shirt shop, you just calculated a gross profit of $145,260, so the question is whether that will cover other costs. Let’s use the information from the example above: 

• You have 2 sales people that cost $50,000 each ($100,000). 

• Rent for the other 600 square feet of the store comes to $21,600 for the year. 

Your gross profit of $145,260 will cover the total of $121,600 in other costs, and you would have $23,660 in operating income if you didn’t have any other costs during the year.  

Demonstrate ROI to future investors or lenders 

Continuing with the T-shirt shop example, chances are that you would have even more expenses, and even if you didn’t, you would want more than $23,660 to at least pay yourself for the year.  

To grow, you have to sell more shirts, so you’re considering multiple options like a working capital loan or inventory financing loan. Imagine you do some planning and figure out the following: 

• You could hire another seamstress at the same cost and the same level of productivity (your current one used half the raw materials you purchased and made 600 shirts). 
• Your sales team is already selling out the shirts you make and you think they could easily sell everything one additional seamstress makes, and they’ll also sell the remaining shirts you have in inventory from last year. 

• You figure you don’t need any other employees or any more space to sell or make more shirts. 

• Because your brand is growing in popularity, you sell your own shirts for $5 more. 

• Everything else remains the same for next year (even the 10 shirts you gave to friends because they wear them proudly). 

Your COGS formula for next year if you hire another seamstress would be: 

Beginning inventory (same as ending inventory from prior year)	$3,790
Current Period Costs (same as last year plus the new seamstress)	$220,260
Ending Inventory	$3,790
COGS	$3,790 + $220,260 – $3,790 = $220,260

 

Your COGS increased from year to year, but so will your revenue. Further, the second year with the new seamstress and with your sales team selling more shirts, you will have the following sales: 

• Vendor purchased shirts: 1,700 shirts at $100 each.
• Manufactured shirts: 1,200 shirts at $205 each 

Your net receipts are now $416,000 and subtracting COGS gives you a gross profit of $195,740. Since your other costs of $121,600 didn’t change, you’re now well past breaking even with operating income of $74,140 ($50,480 more than last year). 

You could then figure in loan payments to assess whether this is good for ROI. For example, say you borrow $25,000 as a buffer and fund the rest of the new seamstress from cash flow.  

• Your terms are 1 year at 15% interest.  
• You would expense the $2,077 in interest, which would bring your taxable income to $72,063. 

But your increased sales also bumped you up a tax bracket, so instead of paying 12% in taxes, you now pay 22%. Here’s how the 2 years compare after taxes: 

	Year 1	Year 2
Taxable Income	$23,660	$72,063
Taxes	$2,839 (12%)	$15,854 (22%)
Net Income	$20,821	$56,209
Change in Net Income		+$35,388

 

Your increase in net income is $10,388 more than the prospective loan amount, so you will have no problem showing a lender that you can repay the loan principal and still have money left over. Now imagine what you’ll do with all of that extra net income next year when you don’t have to repay the loan. And it all started with accurately accounting for costs to calculate the cost of goods sold formula. 

Now that you understand how to calculate and use the cost of goods formula for your small business (whether or not the IRS requires you to use it) and how you can use it to better manage and grow your business, check out other helpful articles on The Bottom Line.