Whether you’re opening up a shop or trying to determine what products to carry over the holidays, you need to calculate the cost of goods sold (COGS). COGS is how much it costs you to produce the products or services that you sell. COGS is more complicated than just the price of buying or manufacturing a product; it also includes costs like labor and raw materials.
And it’s one of the most important calculations you can do when managing your store. As a business expense, COGS is subtracted from your revenue to calculate gross profit. If COGS for a product are higher than the price point you’re selling it at, you’ll lose money every time you make a sale. Calculating the COGS for each of your products will help you set your prices to ensure you’re making a healthy profit margin. It will also help you understand which of your products are profitable and which ones are not.
To calculate COGS for the last year, you need to know your initial inventory, inventory purchases, and final inventory. The initial inventory includes the cost of the products you started the year with, inventory purchases includes any additional product costs accumulated throughout the year, and the final inventory is the cost of the inventory you didn’t sell at the end of the year.
COGS equals the initial inventory plus the inventory purchases minus the final inventory as shown here:
The method you use to calculate inventory will impact your COGS calculation. There are three methods you can use to count inventory:
1. First In, First Out (FIFO)
The FIFO inventory method counts purchases and inventory chronologically. The first inventory purchase made is the first inventory sold.
2. Last In, First Out (LIFO)
Opposite to the first method, LIFO counts the last unit purchased as the first unit sold.
You can also take the average of your inventory, which can keep your COGS more even than the other two methods.
How to Calculate COGS With the FIFO Method
In this example, the cost per mug will differ based on changes in direct expenses, such as labor, raw materials, and overhead. The cost per mug includes these expenses.
For the year, we had five mugs available for sale. At the end of the year, we had four, meaning we sold one mug. Based on the FIFO method, the initial inventory is the one mug sold at $5. This means the remaining four goods (or final inventory) come to a total of $31 (1 x $7 + 2 x $7 + 1 x $10). With the calculation, this your cost of goods sold for the year is $5 ($5 + $31 – $31).
To make a profit on the mugs, you would need to sell them for more than $5. If you sell a mug for $15, its gross profit would be $10 ($15 – $5).
Knowing your COGS will help you to determine which products are best to carry in your store. This is especially important in a brick and mortar store because space is limited and you need to select the most profitable products.