It still amazes me when I watch contestants on the television show Shark Tank, and when one of the sharks asks an entrepreneur what it costs to make their product, and they get a “deer in the headlights” look in response. Then “Mr. Wonderful” will say, “You’re dead to me.” This can be a humiliating experience, but a valuable lesson learned. How can you know if you are making money if you don’t know how much your product costs? In an anonymous survey by VistaPrint, it reflected that over one-third of respondent did not have an accurate handle on their cost of goods sold. Let’s take a lesson from Accounting 101 and make sure we know how to do this.
Cost of Goods Sold Formula
(Beginning inventory costs + Additional inventory costs) – Ending inventory = Cost of Goods Sold
As you can see from the formula, Cost of Goods Sold (COGS) is determined by your inventory. Inventory can be a wide-reaching term, and since COGS has tax implications, it’s important to specify what counts as inventory before calculating COGS. So let’s begin there. Also, don’t be dependent upon your financial software at first. As they say, the data that comes out is only as good as the data that goes in. Get a good handle on what inventory actually is, and then go ahead and make life easier with the software. Here are the factors of inventory.
Cost of Raw Materials: These are the physical components of your product that must be calculated to determine your cost. The following is a simple example of the cost of raw materials to make a cookie:
Make a list of all the ingredients. We’ll take one ingredient, sugar, and step through the chart above. The package of sugar purchased measured 80 ounces, and cost $7.59. Thus, the cost of each unit (ounce) of sugar is $0.095 ($7.95 / 80). Then determine how much sugar you need per cookie (units) and multiply that by the per unit price. In this example, it would cost $.285 to make the desired batch of cookies.
Cost of Labor: Any employee associated with the direct production of a good or service is considered in the cost of labor. This doesn’t include your marketers, salespeople, financial analysts, and other indirect laborers. The following example shows how to calculate the labor cost of making aprons:
The example shows it would take 0.3 hours of labor to make an apron. Simply start the clock and start making one. When finished, you have your labor cost. In our example, the company pays $10 an hour for labor, so to make 100 large aprons, the total direct labor cost would be $300 ($10 x 30 hours).
Additional Costs: Other items directly associated with the cost of producing a good or service is considered an additional cost. This includes:
- Cost of rent for maintaining a factory or warehouse.
- Cost of utilities such as water and electricity used for production.
- Costs of shipping materials and supplies used to produce your goods.
COGS is an accounting term needed to calculate gross profits (Revenues – COGS) and every other line item on an income statement below it. Calculating COGS goes hand in hand with understanding your fixed and variable costs that combine to give you a product or unit cost. Ultimately, the most important reason, after the cost per unit is calculated, is the tax implications. Companies may be able to deduct the cost it takes them to produce goods or services. In most cases, COGS is subtracted from revenue to make your taxable income less. Utilize these steps to get a better handle on what it costs to make your product.