How to Compute Cost of Goods Sold for Your Small Business
As a small business owner, understanding the cost of goods sold (COGS) is crucial for calculating your company’s profitability and making informed decisions about pricing and inventory. In this article, we will discuss the basics of COGS and how it affects your business.
What is Cost of Goods Sold?
Cost of goods sold, or COGS, is the cost of all materials, labor, and other expenses incurred in producing a product or service. Essentially, COGS is the total cost of everything that goes into making and delivering a product to a customer.
How is COGS Calculated?
To calculate COGS, you need to consider two main things: direct and indirect costs. Direct costs are the costs associated directly with the production of the product, such as materials and labor. Indirect costs are those that are indirectly related to the production, such as rent, utilities, and administrative costs.
The formula for calculating COGS is as follows:
Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold
Example:
Let’s say you sell handcrafted wooden tables. At the beginning of the year, you had 10 tables in inventory, which cost you $1,000 to produce. During the year, you purchased additional materials and labor for $5,000, and you ended the year with 5 tables in inventory, which cost you $500 to produce. The calculation for COGS would be:
$1,000 (Beginning Inventory) + $5,000 (Purchases) – $500 (Ending Inventory) = $5,500 (Cost of Goods Sold)
Why is COGS Important?
COGS is important for calculating your business’s profitability and determining your pricing strategy. By understanding the cost of producing your products or services, you can set prices that ensure a profit and avoid pricing yourself out of the market. It also helps you determine when it’s time to raise prices or negotiate with suppliers for better rates.
Conclusion
Calculating COGS is essential for small business owners to understand their profits, avoid underpricing, and make informed decisions about inventory and pricing. Remember to consider both direct and indirect costs in the formula and keep track of your inventory throughout the year. With this knowledge, you can make a more accurate assessment of your business’s financial health and take steps to improve it.
