Why Cost of Goods Sold is Vital to Your Business's Financial Health

To ensure sustainable growth and success for your business, it is crucial to understand the metric of Cost of Goods Sold (COGS). Not only does this metric indicate revenue and profit, but it also directly impacts your business's overall sustainability. Additionally, calculating COGS is necessary for accurately filing business expenses on your taxes.

What Exactly is Cost of Goods Sold?

COGS is a critical metric used in business and sales to determine the value of inventory sold or created within a specific time frame. This calculation considers all direct costs related to inventory, such as raw materials, transportation, storage, and direct labor for manufacturers. Since COGS reflects the cost of acquiring products, it directly impacts profit and revenue. For example, if your COGS exceeds or matches your revenue for a period, it indicates that your business is not profitable, and you have either broken even or lost money.

To accurately benchmark COGS, businesses can compare the metric for a specific time period, such as a day, quarter, or year, to a different time frame of the same length to determine any changes in sales.

How to Calculate COGS

The formula for calculating COGS is straightforward: Cost of Goods Sold = Beginning Inventory + Purchased Inventory – Ending Inventory. For instance, if you are analyzing your quarterly numbers, and at the start of Q4, you had $50,000 worth of inventory, purchased an additional $25,000 to meet holiday demand, and had $20,000 of inventory remaining at the end of the quarter, your COGS for the quarter would be $55,000.

The method of calculating COGS may vary depending on whether you are a manufacturer or retailer. Let's break down both scenarios for clarity.

Examples of Cost of Goods Sold

Retailer Example

For example, if you own a school supply store and sell backpacks, to calculate your COGS, you would consider the cost of purchasing the backpacks from your supplier, shipping fees, and any other expenses directly related to the inventory. This information can provide valuable insights into your business's profitability and growth.

Best Practices for Controlling COGS

As COGS is a vital metric for businesses, it is crucial to make efforts to optimize it. Here are a few recommendations for controlling COGS:

• 1. Negotiate deals with suppliers. Many suppliers are open to negotiations, especially if you buy in bulk, commit to an exclusive agreement, or enter into a long-term partnership. This can significantly reduce your inventory costs without affecting the quality or prices for your customers, resulting in higher profits for your business.
• 2. Organize COGS by category. While tracking COGS over time can provide a general overview of your business's growth and sustainability, breaking it down by product or category can provide more specific insights. This takes discipline and organization, but it can help you identify which products contribute to your bottom line and which ones may need to be reevaluated.
• 3. Consider automation. For manufacturers, investing in automation can be an effective way to reduce COGS in the long run. Although there may be a significant upfront cost, using machines can lower expenses and improve efficiency, resulting in decreased COGS and increased profits over time.

Utilizing COGS to Boost Your Profit Margins

Understanding your Cost of Goods Sold is crucial for measuring the health and growth of your business. By tracking COGS, you can monitor expenses, lower your taxable income, and determine the profitability of your business. Combining this knowledge with your Gross Margin can provide a comprehensive view of how your COGS affects your business's overall profitability and cash flow.