Calculating the cost of goods sold (COGS) provides you with a more accurate picture of your business so that you can avoid common mistakes. With accurate information, you can feel confident when you go to make decisions about buying equipment, raising or lowering prices, and other operational aspects.
When your COGS is not accurate, it can lead to:
- Buying new equipment when it’s not profitable or passing on purchasing new equipment that would have helped you grow.
- Raising prices when you shouldn’t have and losing customers.
- Making bad investments, like spending too much on advertising to drive demand when you don’t need to.
- Not knowing about shrinking (theft issues) until it is too late.
Since every business is different, the Generally Accepted Accounting Principles (GAAP) don’t give a specific list of expenses to include or exclude. GAAP says to use your best judgment. This opens up room for errors, as there are different ways to value and account for inventory, caveats to the tax code, and more.
Five of the most common mistakes made when calculating COGS occur from:
- Including only direct costs for COGS and excluding indirect costs.
- Bad inventory tracking, causing mistakes in calculating the COGS formula.
- Using outdated costs as part of valuing inventory.
- Excluding depreciation from COGS when business forecasting.
- Not adjusting for shrinkage.
If you’re ready to avoid these types of issues so you can focus on growing your business, here are the most common mistakes when calculating COGS, why they’re a problem, and how to prevent them.
Putting the wrong costs into COGS
Putting the wrong costs into COGS makes your gross margins lower than they should be. When your gross margins appear to be lower, it can lead to decisions that hurt your business like:
- Not lowering your prices to take market share from your competitors by undercutting them on price.
- Hiring more people than necessary to try and grow volume when you don’t actually need to grow volume.
- Overspending on advertising to increase demand for your products in order to offset the fixed costs in production.
As a rule of thumb, COGS should only include costs directly related to making or buying the products you sell. The table below shows examples of what you might include or exclude but always talk to a tax professional for guidance specific to your business.
| Direct and included in COGS | Indirect and not included |
| Raw materials Shipping costs from suppliers to your business Inventory purchased for resale Labor directly tied to manufacturing or assembling products Depreciation on equipment used in production Rent, utilities, and insurance directly related to manufacturing Inventory write-offs (theft, damage, obsolescence) Tariffs, import duties, shipping insurance | Shipping products to customers (selling expense, not COGS) Management and administrative salaries (unless specifically for production) Sales commissions, advertising, and discounts |
Bad inventory tracking
Bad inventory tracking is extra harmful because your COGS will be wrong and the mistake compounds over time based on the COGS formula:
- COGS = Beginning Inventory + Purchase – Ending Inventory
This mistake causes COGS errors right now because ending inventory will be inaccurate. Then, because ending inventory is the next period’s beginning inventory, future COGS will also be calculated incorrectly.
When bad inventory tracking causes ending inventory to be too low, COGS will be too high, and you’ll face issues similar to those in the previous section. In addition, by overcounting ending inventory, your COGS will appear to be too low, making your gross margin appear too high. This can result in:
- Dropping prices too far because you thought your margins were higher. This cuts into your profits, making your gross margin negative.
- Underinvesting in marketing because you thought you had enough gross profit to cover other operational costs. This allows your competitors to take market share and lowers both current and future profits.
- Not producing as much product as you should have initially and then running the machines more than you should to catch up. This can cause delays or skipping needed maintenance, making them break down faster.
This COGS mistake also compounds as it uses the previous period’s inventory to start the next period, which is why tracking inventory accurately is important. By having a system for inventory best practices and verifying the documentation when someone else does the count, you’ll be less likely to run into this issue.
Here are some tips for inventory management best practices:
- Invest in inventory management software so you don’t have to fix issues from Excel typos or misread handwriting.
- Define a specific step-by-step process with a checklist for physical inventory counts so that you follow the same procedure every time.
- Do physical checks regularly (monthly or at least quarterly) and verify your physical count with the software records.
- Analyze your COGS versus other costs over time. If you see big differences in the numbers, like sales growing at 20% but COGS declining over time, it could indicate an issue in tracking, and you can stop the problem before it gets out of hand.
Outdated costs in the COGS formula
Outdated costs cause the same problems as the previous sections when you multiply an inventory unit count by an outdated price and get the wrong inventory value.
For example, if you’ve used the same pencil vendor for 10 years and their cost per pencil grew from $1 to $2, but you applied the old cost to your inventory count of 10 pencils, you’d end up with an inventory of $10 instead of the correct $20. This would make your COGS too low. Now you face the same pricing, advertising, and operational issues from COGS calculation mistakes.
Fortunately, it’s easy to avoid this issue by using current cost data. You can go one step further by adding a step in your inventory management process to verify the pricing data from vendors.
Not accounting for better worker productivity will cause this same issue. It might have taken 4 people to manufacture 30 drums each month in the past, but as workers have gotten more skilled, it now takes only 3 people to manufacture the same number. If you’re still including wages for 4 people as part of COGS for 30 drums, then your COGS will be too high.
Depreciation not included in COGS
The IRS doesn’t require small businesses to track depreciation related to COGS separately from depreciation for other operating activities like big businesses have to. When you exclude depreciation from COGS for your small business taxes and don’t keep a separate set of operating books, you’ll think COGS is lower than it should be.
This mistake creates issues when forecasting future growth and evaluating big investments. If you take an equipment financing loan and forget to include depreciation in COGS, it will mess up your break-even analysis by forecasting that fewer units are needed to break even. When this happens, it causes you to buy new equipment that won’t be profitable.
If you don’t include depreciation in COGS for tax time and don’t want to keep an extra set of books, remember to include it whenever you do production forecasting or analysis for new investments.
Not adjusting for shrinkage
Not adjusting COGS for shrinkage (theft) is a common mistake. If you rely only on software without physical inventory counts, you won’t notice missing items. Software tracks inventory based on sales, so stolen items get missed, causing you to overestimate your ending inventory for COGS.
This makes COGS too low and gross margin too high, and it can lead to not lowering prices to gain market share or overspending on advertising and team members when you don’t have to. Additionally, masking the shrinkage problem prevents you from creating new security measures, since you can’t fix a problem that you don’t know about.
This can be avoided with a physical inventory count that you compare with software. Then you can explore why there are differences. Once you know what occurred, you can figure out how to stop it from happening in the future.
By including the correct costs related to COGS, implementing sound inventory tracking procedures, and adjusting for changes in costs or shrinkage, you’ll avoid these common mistakes when calculating COGS and be able to make more accurate business decisions.
