Why Your Cost of Goods Sold is So Very Important | DataDrivenInvestor
Many companies don’t really understand what a cost of goods sold is and don’t calculate it correctly. I’m going to tell you why that’s dangerous.
I get endless writing fodder from my clients. I am currently working with a company that is acquiring another company. My partner and I were retained to calculate a valuation and propose an appropriate deal structure. Easy peasy. Right? Wrong. The target company is a manufacturing company and their cost of goods sold (COGS) was wrong in six ways from Sunday leading to an inaccurate gross profit margin. It is difficult to value a company without a solid COGS and gross profit number. Further, it is difficult to make decisions about your company if you don’t know what your COGS is.
Let’s start with the formula for COGS: beginning inventory plus purchases minus ending inventory. That’s it and it is logical. It’s what you started with (beginning Inventory) plus what you purchased to add to that (purchases) less what you have left over (ending inventory). Why subtract ending inventory? Logically, because it is the Cost of Goods Sold. If you don’t sell it, subtract it out and it will be your ending inventory for this period and your beginning inventory for the next period. Yes, it is calculated for a particular time period. For small companies that is usually monthly, quarterly and then at year end. The idea is that you want to find out exactly what it has cost you to make or buy the products you sell for that time period.
So it is only that. Not sales commissions or whatever it cost you to sell them. Not what it cost you to store everything in your parent’s garage. Not what it cost you to make samples or go to trade shows or advertise. None of that. Just, what it costs to make your products. The only exception to this rule is if you are doing your own actual manufacturing. Then you can include factory overhead expense into COGS for the time period in question.