The cost of goods sold (COGS) is a key component of many small businesses. To determine the profit you make by selling something, you must know how much you spent on the raw materials to create it.
Miscalculating COGS can cause you to pay higher taxes than necessary. It can also give you an inaccurate picture of your company's financial health and lead you to make poor decisions when making strategic plans for your company.
COGS vs. CODB
The level of complexity of COGS, and the method used to calculate it, vary greatly from one business to another. But in general, to determine COGS for a given year, you start with the total value of the inventory at the beginning of the year, add the total of all materials and labor used to create additional inventory during the year and subtract the year-end inventory (inventory remaining after sales, in other words).
The cost of goods sold, however, is not the same as the overall cost of doing business (CODB). Whatever commission you're paying your sales force is not included in your yearly COGS deduction, for example. Those are operating expenses. It's important to understand the difference between the two.
Taking Stock of Inventory
Because annual COGS calculations are based on total inventory at the end of the year compared to the beginning, it is vital to have an accurate system of inventory tracking in place. If you miscalculate your year-end inventory, your COGS will be off — and so will your taxes. (Although it's illegal, some companies misstate inventory intentionally to give an inflated sense of their profitability.) You'll also be basing your forecast for the coming fiscal year on inaccurate numbers.