How To Calculate Cost of Goods Sold

How To Calculate Cost of Goods Sold

If you are a business that sells products it is important to understand how to determine the cost of selling the product. This calculation incorporates all costs associated with selling products. Calculating the cost of goods that are sold (COGS) for products that you produce or sell can be difficult, depending on the number of items in the manufacturing process and on the level of complexity of your manufacturing process.

Cost of Goods Sold and Inventory

In the calculation, the price of goods sold is based on the worth of your company’s stock. If you’re selling physical products inventory is the product you offer. The inventory of your business could include items that you purchased from a wholesaler or you created by yourself and then resold. There is also the possibility of keeping an inventory of the parts or products you design and create. Inventory is a significant corporate asset that has a particular worth.

The method of calculating the value of selling goods begins with the inventory at the start of the year. It ends when inventory is taken at the conclusion of each year. Many companies have a method of making inventory during these times in order to determine the worth of their stock.

The “how-to” takes you through how to calculate the cost of selling goods to you so that you know the process as well as the details you’ll have to disclose to your tax advisor.

Information for the COGS Calculation

Before you can begin you must have the following facts:

The accounting method. The IRS requires firms that manage inventory to be able to account for it by employing accrual accounting. the approach of accrual-based accounting. 1

There is a loophole to this rule only for small-sized firms. If you’re a smaller firm with annual gross earnings of less than $26 million in the last three years, then you might be able to keep an inventory and instead employ the accrual method of accounting. Consult with your tax advisor prior to making any decision regarding cash. the accrual method of accounting. 

Method of costing inventoryIt is essential to know the value of your inventory. The IRS allows a variety of different options ( FIFO or LIFO for instance) according to the kind of inventory. The IRS has specific rules on what methods of identification you can employ and how you can modify the method you use to calculate inventory costs. 3

It is also necessary to gather additional details about the inventory you have:

  • The value of your inventory at the beginning, which is the sum of all items components, materials, and parts that you have in your inventory at the time of the year’s beginning must be equal to the inventory that you will be closing at the close of the year.
  • Cost of purchase (parts materials, parts, and finished products) to maintain inventory
  • The cost of labor, including paying workers to create products and shipping them
  • The cost of materials and other supplies that are used to manufacture and ship items
  • Other costs, like the cost of shipping containers and freight charges, and warehouse costs like electricity, rent, etc.
  • Ending inventory, the amount of all inventory items at the end of the period 

The Basic Cost of Goods Formula

The fundamental formula for selling prices of goods is:

  • The Inventory of the Beginning (at the start of each year)
  • Plus Purchases and Other Costs
  • Minimum the Ending Inventory (at the year’s end)
  • Equals Cost of Goods Sold. 

Steps in Calculating the Cost of Goods Sold

Step 1: Determine Direct and Indirect Costs

The COGS calculation procedure lets you deduct all the costs associated with the items that you sell, regardless of whether you make them yourself or buy them to resell. Include all costs, such as the cost of labor, cost of supplies and materials, and other expenses.

COGS includes two kinds of expenses comprised in COGS:

  • Direct Costs are expenses related to the purchase or production or purchase.
  • Indirect Costs are expenses related to storage facilities, warehouse equipment, labor, and other costs.

This is an illustration of the differences between indirect and direct costs:

  • Direct labor costs are the amount you pay employees who devote all of their time directly working on the products that your company produces including full-time as well as part-time employees.
  • Indirect labor costs refer to wages you pay employees in your company but do not have any direct or immediate connection to making products, like packaging, stocking, and shipping workers. 

Step 2: Determine Facilities Costs

Costs for facilities (for buildings and other places) are among the most difficult to calculate. That’s where the help of a reputable tax professional can help. It is necessary to assign the percentage of your facility expenses (rent and mortgage rates, utility bills, and other expenses) to each product for the period of accounting in the question (usually an entire year, to be used for tax reasons).

Step 3: Determine the Beginning Inventory

Inventory is the inventory of items that are on hand, the raw materials, works in progress completed products, and other supplies that make up a portion of the products you offer. It is possible to take inventory of all inventory items or keep an ongoing daily count during the course of the year.

The beginning inventory you take this year should be the same as your closing inventory from last year. If the two numbers don’t coincide, you’ll need to provide an explanation on your tax form to explain the differences.

Step 4: Add Purchases of Inventory Items

The majority of businesses will add inventory throughout the course of the year. You should keep track of the price of each shipment as well as the manufacturing cost for every item you add to your inventory. When you purchase items, be sure to keep your invoices along with any other documentation. When you produce items you’ll need the assistance of a tax advisor to determine how much you will include in your inventory.

Step 5: Determine the Ending Inventory

Costs for ending inventory are typically estimated through the physical inventory of the products or by an estimate.

Costs for ending inventory can be decreased for defective, worthless, or outdated inventory. If an inventory is damaged, you must provide your estimated cost. If the inventory is worthless it is necessary to prove to show that the inventory was destroyed. If you have outdated (out of the date) stocks, you have to provide proof of the loss in value.

Step 6: Do the COGS Calculation

Now you’ve got all the information needed to complete this COGS calculation. You can calculate it using an Excel spreadsheet, or have your tax expert assist you.

Cost of Goods Sold on Business Tax Returns

The procedure and the form used to calculate the price of the goods sold and include it on the tax return of your business differ for different types of companies.

For sole proprietors as well as single-member LLCs that use the Schedule C as a part of their personal tax returns the price of the item sold is determined in Part III and is included in the section titled Income (Part I) of this Schedule. 6

Here’s how the calculation appears for Schedule C for small-business taxes:

Cost of Goods Sold on Schedule C
Inventory at Beginning of Year $15,500
Plus Purchases 8,331
Plus Cost of Labor 12,350
Plus Materials and Supplies 8,200
Plus Other Costs 1,100
Sub-total $45,531
Minus Inventory at End of Year 18,330
Equals Cost of Goods $27,201

In the case of partnerships multi-member LLCs corporate entities, S corporations for corporations, partnerships, and multiple-member LLCs, the cost of the goods sold is calculated using the Form 1125-A. The form is complex and requires a lot of effort. It’s recommended to consult the assistance of a tax professional through the procedure.

Disclaimer This information provided in this post is general information and is not legal or tax advice. Every business’s situation is unique and tax laws change. You should seek advice from your tax professional to make sure that your calculation is correct.

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