If you’re running a product-based business, one of the most important financial metrics you’ll encounter is Cost of Goods Sold (COGS). COGS refers to the direct costs of producing the goods that a company sells during a specific period. Accurately calculating COGS is essential not only for determining profitability but also for understanding inventory performance, tax implications, and overall financial health.
At the heart of the COGS calculation are two often-overlooked components: Beginning Inventory and Ending Inventory.
What is Beginning Inventory?
Beginning inventory is the value of the inventory that a business has on hand at the start of a financial period. This inventory includes all goods that are available for sale, whether finished or in-process, and is essentially the leftover stock from the end of the previous accounting period.
For example, if you closed last year with $25,000 worth of inventory still on your shelves, that amount becomes the beginning inventory for the new year.
What is Ending Inventory?
Ending inventory, on the other hand, is the value of goods remaining at the end of the financial period. It is determined through physical counts or inventory management systems and reflects what hasn’t yet been sold.
Ending inventory will become next period’s beginning inventory, and its accuracy is critical because it directly affects both your COGS and your reported profit.
The COGS Formula
The relationship between inventory and COGS can be summarized by the following formula:
COGS = Beginning Inventory + Purchases During the Period – Ending Inventory
Let’s break this down:
- Beginning Inventory: What you started with.
- Purchases: New inventory bought or produced during the period.
- Ending Inventory: What’s left over.
What you’ve sold during the period is everything you had (beginning inventory + new purchases), minus what’s still unsold (ending inventory).
Why It Matters
- Accurate Profit Reporting: COGS directly reduces your gross income. If your ending inventory is overstated, your COGS will be understated, and you’ll show an inflated profit. The reverse is also true.
- Tax Implications: Since COGS is deductible as a business expense, its accuracy affects your taxable income.
- Cash Flow Insight: Monitoring inventory levels helps businesses manage cash tied up in stock. Too much ending inventory may signal overstocking or slow-moving products.
- Business Valuation: For business buyers, brokers, or investors, inventory and COGS data provide critical insight into operational efficiency and pricing strategy.
Conclusion
Understanding how beginning and ending inventory impact your cost of goods sold is fundamental for maintaining accurate financial statements and making informed business decisions. Whether you’re preparing for tax season, seeking investment, or just looking to improve margins, take the time to track your inventory correctly—your bottom line depends on it.
