Pricing your products can sometimes feel like a guessing game. Set the price too high, and you risk losing customers who think they’re paying too much. Set it too low, and you might be missing out on profit. It’s a tricky balance that can leave you second-guessing every decision.
But there’s one important figure that can take the guesswork out of pricing: your cost of goods sold. This figure gives you a clear picture of what you spend on your products so you can price them with confidence. It’s how to know you’re covering your costs and still leaving room for profit.
Understanding your cost of goods sold is the first step toward smarter pricing that works for your business and your customers. Let’s explore this crucial figure and how it can transform your pricing strategy.
What is the cost of goods sold?
The cost of goods sold is the total direct cost of acquiring the products a business sells. Simply put, it’s what you spend to make or buy the things you sell to your customers.
This calculation varies by business type. For production-based businesses, it covers the direct cost of making the product. If you don’t make your items, it includes the cost to buy products and get them ready to sell.
In essence, the cost of goods sold reflects the direct investment you make in each item you sell, whether creating it from scratch or buying it for resale.
What to include in the cost of goods sold
If you make your products, the cost of goods sold typically includes direct expenses like:
- Raw materials: The physical ingredients or parts that directly become part of your final product, like microchips for an electronics company or flour for a bakery
- Direct labor: Wages paid to the workers who are hands-on in making your product, such as chefs in a restaurant kitchen or tailors in a garment shop
- Manufacturing costs: Overhead expenses tied directly to your production process, like rent and utilities for your factory space
- Freight: The cost of getting your raw goods or inventory to your business location, such as transportation costs for bringing produce to a grocery store or restaurant
If you buy products to resell, the direct expenses are simpler. They mainly include what you pay suppliers for your products. However, it’s not just the price tag on the product. You must also include extra costs like shipping to your store or packaging if you repackage the items before selling them.
Either way, you’ll likely have some fixed costs, like rent, and variable costs that change with production. It’s important to track these carefully to manage your overall expenses effectively.
What to exclude from the cost of goods sold
Cost of goods sold excludes indirect expenses, such as:
- Selling and marketing expenses: Costs for promoting and selling your products, like advertising or paying your Sales team
- Administrative expenses: General business expenses that aren’t related to production, like office supplies or management salaries
- Distribution costs: The cost of getting your products to customers, such as shipping and handling fees
- Overhead not tied to production: Things like office rent, utilities, or general maintenance that don’t directly involve making your product
These indirect expenses are part of running your business but don’t count toward making each product. Instead, consider them operating expenses and only factor them in when calculating your net profit.
How cost of goods sold shapes your pricing strategy
Cost of goods sold has a specific meaning in accounting. Under the Generally Accepted Accounting Principles (GAAP), product companies must follow certain rules when calculating this number. These rules help ensure everyone’s using the same playbook when figuring out their costs.
Why does this matter? Because your cost of goods sold directly impacts 3 key numbers that can make or break your business: your company’s gross profit, net profit, and gross profit margin.
- Gross profit is the difference between your revenue (the selling price) and your cost of goods sold. It shows how much you have left over after covering the direct costs of creating your product.
- Net profit is what remains after subtracting all direct and indirect expenses from your revenue. It’s the bottom line—the true measure of your business’s profitability.
- Gross profit margin is the percentage of each sales dollar left after covering the cost of goods sold. It helps you understand how efficiently you’re producing and pricing your products.
Together, these 3 numbers are like your business’s financial compass. They help you determine if you’re charging enough for your products or spending too much to make them.
By tracking these metrics, you can spot problems early. If your gross profit is shrinking, maybe your materials are getting too expensive. If your net profit is low, you might need to try different pricing methods. Your gross profit margin shows how much money you make on each sale, which reflects the overall financial health of your business.
With this data, you can make smart choices about pricing and where to cut costs. This way, you’re not just guessing—you’re using real data to steer your business toward better profits.
A simple example of cost of goods sold
If you’re still uncertain about how cost of goods sold guides your pricing, think of it in simple terms. Imagine you run a T-shirt printing business. Your breakdown would include direct costs like:
- Materials: The blank T-shirts and ink for printing
- Raw material shipping: The cost of shipping the blank T-shirts and ink to your business location
- Labor: The wages paid to the workers who print the designs on the shirts
- Supplies: Any tools directly used in the pricing process, like tape, squeegees, and spatulas
- Factory overhead: Costs that directly relate to the manufacturing process, such as utilities or equipment depreciation
You wouldn’t include indirect costs unrelated to producing the T-shirts, like your Cashier’s salary, office rent, or social media marketing costs. Keeping these separate helps you better understand your actual production costs and how much profit you’re making on each sale.
If you add up all your direct costs, you get the total cost of goods sold. For example, if it costs you $10 to produce each T-shirt and you sell it for $25, your gross profit per T-shirt would be $15.
Your gross margin would be 60%. Calculate this by dividing your gross profit ($15) by the selling price ($25) and multiplying it by 100. This calculation tells you that 60% of each sale is gross profit after covering the cost of producing the T-shirt.
Now, if your indirect operating costs, like rent, marketing, and salaries, come to $5 per T-shirt, your net profit would be $10. For every T-shirt you sell, you make $10 in profit after covering every business expense.
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Additional ways cost of goods sold drives business success
Beyond profitability, keeping track of the cost of goods sold helps your business in several important ways:
Supports inventory management
Knowing your cost of goods sold helps you make better decisions about what to keep in stock. It shows you which products are flying off the shelves and which are gathering dust, so you can make or order more of what’s selling well and avoid wasting money on items that aren’t moving.
Helps in budgeting and forecasting
Cost of goods sold is a key part of financial planning. When you know how much it costs to make or buy your products, you can better predict your future expenses, making it easier to set realistic sales targets and create more accurate budgets for your business.
Impacts tax liability and compliance
Your cost of goods sold directly impacts how much tax you pay. Generally, a higher figure means lower taxable income, which could lead to a smaller tax bill. But it’s crucial to calculate and report your cost of goods sold correctly to stay compliant with income tax laws.
How to calculate cost of goods sold
Calculating the cost of goods sold is as simple as adding your beginning inventory and purchases and then subtracting your ending inventory. The basic formula looks like this:
Beginning inventory + purchases - ending inventory = cost of goods sold
Here’s what each part means:
- Beginning inventory is the value of your inventory at the start of the accounting period. It includes all the products or raw materials on hand that did not sell in the previous period.
- Purchases include all the direct costs of products you bought or made during the period for resale.
- Ending inventory is the remaining inventory’s value at the end of the accounting period. It reflects the products that are still unsold and available for future sale.
This formula works for all types of businesses, but what counts as purchases depends on whether you make or buy your products. It even works for companies that do both.
Let’s look at how this works for a bakery that makes and resells products. Here’s a simple monthly cost of goods sold calculation:
- You start with $2,000 worth of goods (beginning inventory).
- During the month, you spend $2,000 on baking ingredients and $1,500 on items to resell, equaling $3,500 in total purchases.
- At the end of the month, you have $1,800 worth of goods left (ending inventory).
Your cost of goods calculation would be: $2,000 + $3,500 - $1,800 = $3,700
This $3,700 represents your total cost for all goods sold that month, whether baked in-house or purchased for resale. With this figure, you can better understand the true cost of your sales, no matter how you source your products.
For a more detailed cost analysis, you can calculate the cost of goods sold separately for the items you make and those you buy to resell. This approach helps you track how much profit each type of product brings in. You can see which products make you the most money, so you know where to focus your time and resources.
Common cost of goods sold accounting methods
When calculating your cost of goods sold, you can use several accounting methods to value your inventory. Each method can result in a different figure, which, in turn, affects your reported profit.
First in, first out
The first in, first out (FIFO) method means that the first items you buy or make are the first ones you sell. So, when you sell products, you use the oldest item’s costs incurred first. It’s often used by businesses with perishable goods, like food or medicine, because it ensures older products sell before they spoil.
The FIFO method is popular because it aligns with the natural inventory flow, making it easier to manage stock levels. By selling older items first, your business can reduce waste and improve inventory turnover, leading to better cash flow. Additionally, it can lead to higher profits during inflation, as older inventory typically has lower costs.
Last in, first out
The last in, first out (LIFO) method works the opposite way. The most recent items you buy are the first to sell. In this practice, you account for the newest inventory’s costs first.
The LIFO method often leads to higher costs and lower profits on your income statement, especially when prices are increasing. While not as common as FIFO, some businesses choose LIFO because it can lower their taxes in the short term.
Keep in mind that LIFO isn’t allowed everywhere and is primarily in use in the United States. If you’re considering using LIFO, it’s a good idea to talk to a tax expert first.
Weighted average cost method
The weighted average cost method calculates the cost of goods sold by averaging the cost of all items you have for sale during a period. In this method, every item sold has the same cost, regardless of when it was bought or made.
This method is popular because it’s simple to use and understand. It also helps even out price changes over time, which is helpful if your inventory costs vary a lot. Overall, the average cost method provides a balanced approach between FIFO and LIFO.
Special identification method
The special identification method tracks the actual cost of each specific item sold. This approach is great for businesses that sell unique or high-value items, like cars, artwork, or custom products.
With this method, you record each item in your inventory and its exact cost. When you sell an item, you use its specific cost to calculate the cost of goods sold.
This method lets you match costs directly with sales, giving accurate financial information. However, it can be a bit tricky if your business has a lot of similar items, as it requires careful tracking of each one.
Calculate cost of goods sold to enhance profitability
Your cost of goods sold is the key to knowing how much it truly costs to sell your products. When you see that figure on your financial statements, you can make smarter choices for your business. Take a good look at the numbers, pick the best way to calculate them, and use this knowledge to fuel your growth. After all, in business, knowing isn’t just power—it’s profit.