If you are a small manufacturing business, calculating your Costs of Goods Sold (or your “COGS”) can be one of the most difficult things to figure out confidently.
We guide you through the world of COGS: how it is calculated, why you should use the COGS method, and also, along the way, give you some tips on organizing your records to make it super simple.
What is Cost of Goods Sold?
Let’s start with the very basics: COGS is shorthand for your “Cost Of Goods Sold”.
Essentially, this is what it costs you as a business to create the products you sell in a financial year.
The “cost” part of COGS is mainly tallied from the materials you purchased to create your product. For example, if you make ceramic products, your COGS would mainly be calculated from the cost of your clay.
If you make dresses, your COGS primarily comes from your fabric, zips, and buttons.
Obviously, the more complex your production processes are and the more materials involved, the more varied and difficult to calculate your COGS will be.
COGS is one of the primary factors determining business profitability; get this calculation wrong, and you could end up significantly overpricing (or underpricing) your products. And if this happens, you can say “bye-bye” to your profits and your business’s growth.
With this in mind, let’s look now into the finer details of calculating COGS.
How to Calculate Cost of Goods Sold: The Formula
To calculate COGS, the formula is as follows:
Beginning Inventory + Additional Inventory - Ending Inventory = Cost of Goods Sold
Let’s break down each component of the COGS equation further.
Beginning inventory refers to the value of your stock at the start of a financial year. This includes all raw materials used in your production process, such as clay or fabric.
This is the value of any additional stock you purchased during the financial year. It could be a new batch of clay, wood, fabric, zips, or buttons — anything that adds to your raw materials inventory.
Ending inventory refers to the current value of your unsold stock at the end of a financial year. This means that if you have leftover clay, fabric, zips, or buttons at the end of the financial year, they must be accounted for in your COGS calculation.
Read more: How to calculate your Ending Inventory
How to calculate Cost of Goods Sold without having an ending inventory
This is a common question, particularly for those who are switching to using COGS for the first time: how do you calculate your COGS if you don’t have an ending inventory for the prior year?
Perhaps you have been indirectly expensing all materials for your first couple of years of operation and you now want to switch to using COGS: how do you go about it?
In general, you’ll want to continue directly expensing all materials until the end of the financial year (i.e. Dec 31). At this point, your ending inventory will be $0 as you have already completely and fully expensed all stock. In your next tax return, you’ll use 0 as your Starting Inventory, and via calculating your Purchases (Additional Inventory) you’ll build up your inventory valuation to arrive at an Ending Inventory for the end of the next year. From this point forward, you’ll always have a Beginning and Ending Inventory to work out your COGS calculations.
As with all big financial decisions, discussing the finer details on how best to switch your Inventory Valuation Method with your accountant before proceeding is best.
Cost of Goods Sold Examples
It’s often easier to understand formulae like the above using real world examples. Let’s look at two examples from some typical small manufacturers.
COGS Example A: The Woodworker
Suppose you’re a woodworker. Your Beginning Inventory (the stock of wood and other materials at the start of the year) is $3,000. Throughout the year, you purchase Additional Inventory worth $7,000. By the end of the year, your Ending Inventory (unsold materials) is $2,000.
Let’s apply our formula:
$3,000 (Beginning Inventory) + $7,000 (Additional Inventory) - $2,000 (Ending Inventory) = $8,000 (Cost of Goods Sold)
In this example, your COGS as a woodworker for the financial year is $8,000. This is the actual cost incurred to produce the wooden goods sold during the year.
COGS Example B: The Soapmaker
Now let’s consider a soapmaker. The Beginning Inventory (the initial stock of soap base, essential oils, and other soap-making materials at the start of the year) is $2,500. Over the year, Additional Inventory worth $5,500 is purchased. At the end of the year, the Ending Inventory (unsold soap-making materials) is $1,500. We apply the same formula:
$2,500 (Beginning Inventory) + $5,500 (Additional Inventory) - $1,500 (Ending Inventory) = $6,500 (Cost of Goods Sold)
In this scenario, the COGS for the soapmaker for the financial year amounts to $6,500. This represents the actual cost of manufacturing the soap products sold during the year.
How do you decide what stock should be included in your COGS calculation?
Your COGS stock calculations for beginning and ending inventory should include all materials that went into getting your product into a saleable condition.
For small manufacturing businesses, this will generally fall into one of two categories:
Cost of Materials: This is the cost you spent in obtaining the materials you needed to create your product. This should include any shipping costs you have paid in order to have the material delivered to you (this is otherwise known as your “landed cost”)
Cost of Packaging: This is the cost of packaging up your product for presentation reasons. Examples include jewelry boxes, labels, and ribbons to tie soap bars together. This calculation should not include any packing materials (e.g., the cardboard box you ship the product to the customer in).
What costs should NOT be included in your COGS calculation?
Costs typically not included in COGS include:
- Cost of your internal labor
- Postage and packaging
- Rental of workshops or office premises
- Payment processing fees
- General office expenses
COGS relates only to the cost to bring the goods to a saleable point, so these fees are considered outside of the scope of this objective and thus not directly related to making your products (in accountant speak, this is known as an “indirect cost”).
☞ Read more about the difference between indirect and direct costs →
COGM or COGS?
COGM (Cost of Goods Manufactured) and COGS (Cost of Goods Sold) are two terms that are often used interchangeably, but they have different meanings. COGM refers to the total cost incurred in the manufacturing process, including direct materials, direct labor, and manufacturing overhead.
On the other hand, COGS only includes the costs related to producing finished goods that were sold during the financial year. COGM is used for internal reporting purposes, while COGS is reported on tax returns and financial statements.
☞ Read more about the differences between COGM and COGS→
How do you report COGS to the tax man?
In the US, the IRS requires all sole proprietors/partnerships to submit details about their COGS via a annual form called a “1040 Schedule C”.
If you are an incorporated business (Inc.) in the US, the form to note is Form 1125-A (Cost of Goods Sold).
The IRS sets out how it wants you to calculate this figure via the forms itself. Using the Schedule C form as an example, you’ll need to find six different COGS calculations and then enter them on separate lines.
Your “COGS” is then a simple final tally from here.
For the Schedule C, the relevant lines are located in Part III: Cost of Goods Sold:
- Start of Year Material Inventory Value
- Purchases (Less Personal Use)
- Cost of External Labor
- Materials & Supplies (these are not your materials in most small business cases as they are factored into 1 and 6) Other Costs (Overheads)
- End-of-Year Material Inventory Value
Why Should You Use the COGS Method?
Now that we understand what COGS is and how it’s calculated, let’s talk about why you should use this method.
As a seller of products you make yourself, it’s firstly important to realize that from an IRS perspective, you are seen as a “manufacturer” rather than a seller of goods or services.
This means that the tax man will expect to see a significant amount of your expense deductions as part of your COGS: in other words, most of your costs of running your business are in buying the materials to make your products.
If you don’t have the COGS expense deductions to match this expectation, then it can possibly invite the possibility of tax audits and further scrutiny (these are obviously things every business wants to avoid).
Other than the threat of the tax man breathing down your neck, there are actually some great benefits to tracking your expenses as COGS - especially if you are in the “growth stage” of your small business.
Tracking and claiming your material usage as COGS allows you to purchase your materials in bulk / ahead of time without needing to use them in the financial period. This means you can purchase your materials now, or whenever you need to and gradually offset your costs against your revenue as you grow.
Using a quick COGS example to illustrate this point, Susan purchases $10,000 of material stock in the first year of her business but only uses $2,000 in manufacturing her products - leaving her with a leftover $8,000 material inventory.
If claimed as a straightforward deductible expense, the $10,000 would completely be claimed in year 1 of the business against the minor revenue made in year 1 which wouldn’t have much of a positive impact for her tax situation.
In year 2, as it has already been fully claimed, $0 of the value of this stock can now be claimed against year 2 revenue even though it has been used to create a proportion of the products sold in this period.
If Susan experiences good growth in her business in Y2 and uses the $8000 of materials, absolutely none of the value of it can now be offset against the now significant revenue for this year as it has already been claimed - this can add up to significant loss of deductions and a heftier tax bill as you are trying to build your business.
Other than the clear advantage of cashflow and accurate tax reporting, there are a a lot of other very good reasons why businesses should use the COGS method:
- Accurate pricing: COGS helps you determine the actual cost of creating your products, allowing you to set prices that cover all expenses and generate profits.
- Better decision making: By knowing how much it costs to make each product, you can better assess which items are profitable and which ones are not, helping you make informed decisions about product lines and future investments.
- Improved tax preparation: As mentioned earlier, the IRS requires COGS information to be reported on specific forms. By accurately tracking your COGS, you can easily fill out these forms without worrying about making mistakes and potentially facing penalties for incorrect reporting.
- Future growth potential: Knowing your COGS helps you better understand your profit margins. This knowledge allows you to make strategic decisions to help your business grow and expand.
Software to help calculate your COGS
Utilizing spreadsheets to calculate cost of goods sold can initially be an effective and cost-efficient approach, especially for small-scale businesses with limited inventory.
These traditional tools empower businesses to exercise a degree of control over their expenses, enabling them to record and process data related to the direct costs of producing their goods or services. However, as a business scales and its operations grow in complexity, the task of managing these spreadsheets can become arduous and error-prone.
The sheer volume of data, coupled with the need for frequent updates and adjustments to reflect the changing inventory and costs, makes spreadsheets a less viable option.
Besides, the lack of automated features and real-time data analysis can substantially increase the chances of inaccuracies, leading to potential misjudgments and business losses.
Thus, reliance on COGS spreadsheets over time may prove more unwieldy and less beneficial for businesses seeking growth and efficiency.
Implementing software to automate calculating COGS is highly beneficial and an excellent choice for any manufacturing businesses looking to scale.
Investing in good Cost of Goods Sold software can streamline your COGS calculation process, saving you valuable time and minimizing the risk of human error.
This software not only calculates COGS but also keeps track of inventory, enabling you to have a firm grasp on your manufacturing costs and how they impact your bottom line.
Craftybase MRP is designed with small businesses and makers in mind, so it’s tailored to address the unique challenges you face when calculating COGS and managing product inventory. It takes into account all the variables involved in your manufacturing process, providing you with accurate, real-time data that you can use to make informed business decisions.
Best of all, Craftybase offers a free trial, allowing you to experience the advantages of automated COGS calculation firsthand before committing to a subscription. Why not give it a try today and see how it can simplify your COGS calculation and enhance your business operations? Start your free trial with Craftybase now →.
How to calculate your COGS automatically using Craftybase
As we have discussed above, to calculate your COGS for the IRS requires 6 different figures:
- Inventory at beginning of year
- Purchases (Less Personal Use)
- Cost of External Labor
- Materials & Supplies
- Other Costs
- Inventory at end of year
We’ll show you how to obtain these tallies from your Craftybase reports.
Inventory at Beginning of Year
The total value of all materials in stock on the first day of the year, plus the material cost of all unshipped stock. Note: your internal labor costs are not included in this total, it is materials cost only.
To generate this number, navigate to your Schedule C Guidance report, run this report for the date range of the date range required, and take the number next to the section called “Inventory at Beginning of Year”.
Alternatively, you can generate this tally via your Material Valuation report by running the report for the date range required and taking the number in the Total Value row in the Starting Value column.
Purchases (Less Personal Use)
This is your total material expenses for the year, minus any materials or products you have removed from your inventory for Personal Use.
To generate this number, navigate to your Schedule C Guidance report, run this report for the date range of the date range required, and take the number next to the section called Purchases less cost of items withdrawn for personal use.
Cost of External Labor
If you have employed anyone to assist you with your craft business during the year then you would account for this cost here. Keep in mind that this cost is mainly for official employees (that will have a W2). Contracted and casual workers should be instead factored in at Part II, Line 11.
If you have been tracking external labor as an overhead expense with a specific category in Craftybase, you can use the Expense Category Report to generate this number (if you are tracking in this way, you’ll want to ensure you remove this category and tally from your Part II)
Materials & Supplies
This section is reserved for any materials and supplies not already included in your start and end inventory totals above that are also not being claimed as supplies in Part II.
If you have been tracking extra materials and supplies as an overhead expense with a specific category in Craftybase, you can use the Expense Category Report to generate this number (if you are tracking in this way, you’ll want to ensure you remove this category and tally from your Part II)
This section is to provide a way of accounting for any other costs directly related to your products that don’t fit into the available categories above.
If you have been tracking other costs as an overhead expense with a specific category in Craftybase, you can use the Expense Category Report to generate this number (if you are tracking in this way, you’ll want to ensure you remove this category and tally from your Part II)
Inventory at End of Year
The total value of all materials in stock on this date, plus the material cost of all unshipped stock. Note: your internal labor costs are not included in this total, it is materials cost only.
To generate this number, navigate to your Schedule C Guidance report, run this report for the date range of the year you need this report for, and take the number next to the section called “Inventory at End of Year”.
Alternatively, you can generate this tally via your Material Valuation report by running the report for the date range required and taking the number under the Total Value row in the Ending Value column.
As we have discussed in detail, COGS is an essential aspect of running a successful manufacturing business and is the key to guaranteeing your future growth.
By following the formula outlined here and keeping track of all relevant inventory costs, you will have a much clearer picture of your expenses and profitability. Additionally, using the COGS method can benefit your business in various ways, from determining accurate pricing to making strategic decisions for future growth.
An important note: Always consult with a tax professional or accountant for specific guidance on calculating and reporting your COGS accurately as rules and regulations can differ.
With the knowledge of how to calculate COGS under your belt, you will be better equipped to run a profitable business and continue doing what you love best: making products for your loyal customers!
Here are some other questions about COGS asked by our readership:
When should I claim for COGS?
For accounting purposes, COGS are treated as an expense in the period the business recognizes income from sale of the goods. This means that you should claim the cost only in the year that your product was sold.
Can I include my labor in the COGS calculation?
In the US, claiming of hired labor costs (i.e. not your own labor) can be included in the calculation, however any of your own internal labor costs cannot be included in COGS.
Does Cost of Goods Sold include transaction or listing fees?
Usually no - selling fees (such as Etsy Listing fees or Shopify transaction fees) are best categorized and claimed as “selling expenses” as they are usually generated after the product has been made ready for sale. This rule can vary depending on your country of residence, so it’s worth checking with your financial authority to make sure.
Is packaging part of COGS?
No, packaging is not typically considered part of COGS (Cost of Goods Sold). COGS refers to the direct costs associated with producing goods or services for sale, such as materials and labor. Packaging is usually treated as a separate expense and falls under the category of operating expenses, which includes all other costs necessary to run a business. However, there are some exceptions where packaging may be considered part of COGS. For example, if a product’s packaging is essential to the production process and cannot be sold separately, it may be included in COGS. Additionally, companies that manufacture and sell their own packaging materials may include those costs as part of their COGS.