Why and How to Calculate Cost of Goods Sold

Periodic financial reporting requires companies to calculate cost of goods sold. This is just one of the three major categories of expense that must be reviewed for strategic cost strategy implementation. Profitability in any industry relies on the relationship between top line revenue and bottom line expenses.

First, understand that only businesses that carry and sell inventory need to calculate cost of goods sold. It is a measure specifically intended to address the cost of selling a product. Because the equation considers both direct and indirect costs, it is a useful tool for evaluating overall financial success of the company.

Cost of goods sold has a significant impact on bottom-line Net Operating Profit Before Taxes (NOPBT).

Cost of goods is often estimated or calculated monthly when a company uses General Ledger forms of accounting in a traditional Profit and Loss statement environment. Because it is applied periodically, it helps clarify the overall financial picture of a company.

Cost of Goods Sold for Retail and Wholesale Distributors (Non-manufacturing)

When you calculate cost of goods sold, you start with

• the inventory value at the beginning of the period,
• add purchases during the period,
• add the cost of labor, cost of freight, and
• subtract the inventory value remaining at the end of the period.

Cost of Goods Sold for Producers (Manufacturing)

To calculate cost of goods sold for manufacturing companies, the simplest method is to

• calculate your cost of goods manufactured,
• add the value of your opening goods inventory and
• subtract the value of your closing goods inventory.

The earlier calculation of cost of goods manufactured should adequately account for both direct and indirect manufacturing costs.

After you calculate cost of goods sold, it is transferred to the periodic income statement of the business. When management is considering budgets, a key focus should be looking at opportunities to reduce COGS.

Strategic cost control strategies allow companies to take what they learn from the COGS and look for opportunities to cut direct and indirect contributing costs.

Some areas of opportunity for cost reduction range from low cost country sourcing to increased use of automation. Many companies find that centralizing spending through investment in e procurement and other spending controls lower some of the variable direct and indirect material costs.

However your company chooses to use the information, it is critical that any company selling inventory, review and act on this core financial data.

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