As a business owner, you’re constantly monitoring different metrics and figures to see how your operations are performing, and what you can improve upon.
But did you know there is one number that virtually every business should know if they want to be successful? No matter what kind of products or services you provide, cost of goods sold (“COGS” for short) is the one number that you need to pay attention to. Your COGS basically tells you how much you are spending to produce each unit of whatever it is you sell.
In this post we’ll provide some insight into why COGS is an essential piece of information for business owners like you to understand, how to calculate cost of goods sold, and how to optimize your COGS. Let’s get started!
1. What Is the Cost of Goods Sold?
On a high level, COGS represents the cost of merchandise that a retailer, distributor or manufacturer has incurred for those items. COGS is almost always reported on a company’s income statement, and is used to calculate gross profit when subtracted from a company’s revenue. Gross profit (or gross margin) is how much money a company makes on the sales prior to subtracting costs like operating and administrative expenses. It tells business owner how effective the company is able to turn inventory into profit. Keep in mind that there are variances on the actual COGS calculation depending on the specifics of each business.
2. How Is Cost of Goods Sold Calculated?
The basic calculation of COGS is the sum of all direct costs associated with producing any given product or service. This usually includes many of the following: parts, ingredients, direct assembly labor, factory labor, and e-commerce merchant fees. Marketing or sales labor expenses need not be included. Take a car, for example. The COGS for an automobile would include the expenses for car parts and factory labor, but not the salary of the salesperson on the car lot.
Here is how you can calculate COGS easily via the most commonly accepted formula:
Beginning Inventory + Inventory Purchases – End Inventory = Cost of Goods Sold
3. Why Is Understanding Cost of Goods Sold Important?
Having a firm grasp on COGS helps a company pinpoint how profitable it is to sell any number of its products or services. From COGS, you can then make the gross margin calculation. The sum of the gross margin is the money you’ll have remaining to pay for salaries and other fixed costs. Understanding COGS and how it plays a key role in analyzing other important financial metrics will help you build a true competitive advantage for your business.
By now you should be convinced that cost of goods sold is the one number that you need to know in order to maximize the efficiency of your businesses. By knowing how to calculate cost of goods sold and the importance it plays in analyzing the financial and operational health of your business, you’ll be able to steadily impact your bottom line in a positive direction.