Cost of goods sold (COGS) is a key business metric for retail business owners seeking to learn more about their business’s overall gross profit and long-term growth prospects. This data point can impact your taxes, pricing model, and even your personal income, according to the US Chamber of Commerce.
In this short explainer, we’ll dive into the ins and outs of COGS in retail, how to calculate COGS, and some ways to keep this expense category under control.
For any merchants just starting out, COGS isn’t as straightforward as it may sound. Cost of goods sold refers to the basic, direct costs associated with producing the products sold by your retail business. What’s included in COGS are things like raw materials and labor used to create the product itself. COGS does not include indirect expenses, such as distribution costs or overhead.
In a retail setting, the cost of goods sold usually equals the price you pay a manufacturer or wholesaler to provide the product, in addition to shipping and handling.
This definition may sound broad. Fortunately, there’s a cost of goods sold formula that retailers can use to calculate this expense category for their own purposes. In retail, the cost of goods sold formula is:
(Starting Inventory + Purchases) – Ending Inventory = Cost of Goods Sold
To use the cost of goods sold formula, you need a few pieces of information:
One of the trickiest parts of calculating COGS is understanding which direct and indirect costs apply to your COGS. Most of the costs included in your calculation will be direct costs. However, since COGS can impact your taxes—more on this in a minute—some business owners claim certain indirect costs, such as overhead costs at the manufacturing site. If you’re not sure what to include, consult a tax professional who can give you more tailored advice.
If this feels overwhelming, the simplest way to calculate COGS is to use change in inventory. For instance, if 200 units are made or bought, but inventory rises by 50 units, then the cost of 150 units is the cost of goods sold. If inventory decreases by 50 units, the cost of 250 units is the cost of goods sold.
COGS is an important metric to monitor regularly since it impacts many areas of your business. For instance, a high COGS can start to eat into your profit margins and make sustainable growth difficult. A high COGS may indicate that you may be carrying too much inventory, or that your pricing model could use fine-tuning.
Some retail business owners use COGS as the basis for pricing their products. This strategy uses COGS as the baseline, or minimum price charged to the customer. The business owner will add a percentage on top of the COGS baseline to create a profit margin, as well as to cover indirect costs.
COGS also impacts your taxes. Retailers need to calculate COGS to write off the expense according to IRS rules and thereby decrease their tax burden. Note that a higher cost of goods sold may mean paying less tax—but it also means your retail business is making a smaller profit.
Of course, inflation and supply chain issues in recent years have meant that many retailers can’t directly control their cost of goods sold. If you see costs start to rise, pay attention: it could be that you need to adjust your pricing model or that customer tastes have changed. To understand what might be going on, check out our guide, “How small businesses can analyze and improve their profit margins.”
And, for more ways to keep track of critical business data, download our free ebook 5 Numbers Every Business Owner Should Watch.
This information is provided for informational purposes only and should not be construed as legal, financial, or tax advice. Readers should contact their attorneys, financial advisors, or tax professionals to obtain advice with respect to any particular matter.
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