What Is the Relationship between Inventory and Cost of Goods Sold?
The cost of goods sold (COGS) is a component of the value of a company's inventory. Inventory and cost of goods sold have a directly dependent relationship in practice and on the books. In practice, a company cannot have inventory without also having proportionate costs that allowed it to generate that inventory. On the books, the COGS is subtracted from revenue to establish gross margin, or the amount of profit made on the sale of the company's inventory.
COGS is an expense category that compiles all of the direct costs incurred to produce and sell a company's products, or the direct costs of turning inputs into revenue. Depending on the type of business being studied, the relationship between inventory and cost of goods sold can be more or less complicated. For example, for a manufacturing business, this includes the cost of raw materials, direct labor costs to produce the goods, the proportion of facility costs that can be directly assigned to the manufacturing process and the direct cost of the sales force used to sell the goods.
In a retailing business, however, the COGS is simply the cost of buying inventory from a wholesaler or manufacturer, the cost of preparing it for sale and the cost of selling it. The relationship between the two in a manufacturing setting is somewhat more complex. Typically, it is easier in a retail setting to segment out the appropriate costs that should be assigned to the COGS category.
The most relevant connection between inventory and COGS is the way the two relate to establish a company's profitability. Revenue is the amount of money a company takes in as a result of selling its products. This number is important, but it does not reflect whether a company is making money or losing money. Profitability can only be determined once a business owner subtracts out the costs incurred in generating that revenue.
At the most basic level, a company needs to know its gross margin, or the profit made on turning over its inventory before it considers additional expenses like taxes. To figure this out, the cost of producing and selling the inventory, or COGS, is subtracted from revenue. Inventory and cost of goods sold are inextricably connected in this analysis because the use of the value of these two categories exposes basic business facts, such as whether an owner is pricing his goods for sale at a level that will make him a profit.
How To Calculate Ending Inventory and Cost of Goods Sold
The formula for calculating ending inventory and COGS is relatively simple, but gathering the data itself can be complex depending on your business operations. Keeping careful records of purchase costs, labor costs and manufacturing costs can make this process much easier. It’s important to understand that all of these categories refer to total monetary values, not actual inventory units.
Calculating Ending Inventory
To calculate your company’s ending inventory for the year, follow this formula: Beginning inventory + purchases (or new inventory) - COGS = ending inventory. Here’s an example of this formula in action:
- Manufacturer X has $20,000 in beginning inventory
- Manufacturer X produces another $50,000 worth of inventory
- Manufacturer X spent $40,000 on goods sold during the year
- The formula is $20,000 + $50,000 ($70,000) - $40,000 = $30,000
- Manufacturer X has $30,000 in ending inventory
Understanding Terms Used in Formulas
Beginning inventory is the value of your business’s inventory at the start of the year. You can use the ending inventory from last year’s profit and loss records for this number.
New inventory or net purchases refer to the costs of buying inventory or manufacturing products during the current year. A simple way to find this value is to subtract any returns or discounts from the gross purchase amount for the year.
The cost of goods sold refers to the price of manufacturing products or buying inventory that was sold during the current year. This amount is subtracted from the beginning inventory and net purchases to find out the monetary value of your business’s remaining inventory.
Ending inventory is the value of your company’s inventory that has not been sold by the end of the year. The value is the purchase price or manufacturing cost, not the sale price.
Calculating Cost of Goods Sold
To calculate the cost of goods sold, use the following formula: Beginning inventory + net purchases or new inventory - ending inventory = COGS. Here’s what this formula looks like in practice:
- Your business has $10,000 in inventory at the start of the year
- You buy $9,000 in new products during the year
- Your company still has $6,000 in inventory at the end of the year
- The cost of goods sold is $10,000 + $9,000 - $6,000 = $13,000
- COGS is $13,000
The value of COGS can be used on the annual balance sheet to determine gross profit or gross income. The balance sheet is designed to look at your business’s financial health during the year. Knowing your gross profit can help you see how well your business is managing costs versus generating revenue.
Assigning Value to Inventory
A common question is how to calculate both ending inventory and COGS since both elements are used in different formulas. First, you need to assign a value to your company’s inventory. There are several ways of doing this:
- First-in, first-out: FIFO accounting uses the costs of the oldest items of inventory purchased or manufactured to calculate COGS.
- Last-in, first-out: LIFO accounting bases the COGS on the cost of the last items manufactured or bought.
- Weighted-average cost: WAC accounting adds up the total costs of inventory during the year and divides it by the total units produced or purchased. This gives an average value to each item.
The method of calculating inventory value you use isn’t something you can just choose randomly. You need to follow the IRS’s guidelines for the size of your business and your industry. The same method is generally followed year after year for accurate accounting.
How Does an Increase in Inventory Affect Cost of Goods Sold?
The effect of buying more products depends on the accounting method your business uses to calculate inventory costs. With LIFO accounting, high prices can increase the amount of COGS and reduce net income. With FIFO and WAC accounting, buying additional inventory only has a minor impact if any on the final COGS value.
It's important to remember that COGS only applies to products that are sold within the target period. The costs of inventory that hasn’t been sold during the year aren’t included in COGS calculations. It wouldn’t appear as an expense on income statements. Instead, these excess products would appear as a current asset in the space marked “inventory.”
Are Cost of Goods Sold an Expense?
The cost of goods sold is counted as a business expense in accounting records such as profit and loss statements. COGS is one of the factors to consider when looking at your business’s bottom line. It’s an unavoidable cost of doing business for retailers, wholesalers, resellers, manufacturers and other companies that rely on inventory for profits.
Is inventory the only cost included in the cost of goods? No, typically all cost associated with acquiring the inventory is also included.
I make handcrafted items from home and sell them online. I need to calculate cost of goods and inventory to determine my profits.
I have calculated the cost of goods already since my main cost is raw materials. Next is inventory but I'm a little confused about this process because I have crafts that are already completed as well as ones I'm still working on. So I don't know the exact cost of the ones I'm not finished with yet.
In order to calculate the cost of goods correctly, how should I take inventory?
Is inventory the only cost included in the cost of goods?
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