How to Calculate Cost of Goods Sold

Retailers, manufacturers, and distributors are known for their low margins. One reason why these businesses' margins tend to be on the low side is that all three need to buy inventory, which will subsequently be sold at a higher price. This expense incurred while turning over a company'sinventory, known as cost of goods sold, is an important number for investors to understand because it can show how profitable a company is on a basic level. Here's how an investor can calculate the cost of goods sold for a company, and how to make good use of that number.

What is the cost of goods sold?The cost of goods sold is the cost of the merchandise that a retailer, distributor, or manufacturer has sold. It is reported on a company's income statement, and when subtracted from revenue shows a company's gross profit. This gross profit, also known as gross margin, is how much money a company makes on the actual sale of an item before deducting costs such as sales, general, and administrative expenses. Basically, it tells us how well a company turns inventory into profit.

How is the cost of goods sold calculated?We can calculate the cost of goods sold by using the following equation:

Beginning Inventory + Inventory Purchases End Inventory = Cost of Goods Sold.

This calculation factors in a company's ever-changing inventory to determine how much money it is making by selling products from this inventory. A simple example would be a retail store that is continually updating its inventory. That store starts the month with $500,000 in inventory, buys another $250,000 in inventory during the month, and after strong sales ends the month with $400,000 in inventory. In this case its cost of goods sold would be as follows:

$500,000 + $250,000 - $400,000 = $350,000

If that store's revenue was over $350,000 for the period, its gross margin would have been positive. However, if revenue was less than the cost of goods sold then that retailer could be in a lot of trouble.

A real life example of why cost of goods sold mattersMore often than not the easiest way to find the cost of goods sold is to review a company's annual report. That is where investors can find a company's income statement, which contains its cost of goods sold, or cost of sales. For example, in Ford's annual report its automotive cost of sales is already calculated for investors; in the screenshot below it is noted as the first line item under costs and expenses:

Source: Ford Motor Co. Annual Report.

An example of where cost of goods sold comes in handy is in tracking Ford's automotive gross margin, which from the screenshot above we can easily identify over the past three years. By first calculating the company's automotive gross profit and then its automotive gross margin as a percentage of sales, we can see that gross margin fell from 12% of sales in 2012 to just 9% of sales last year. That's a result of Ford's automotive cost of goods sold rising as a percentage of automotive revenue as the company spent more on inventory. Some Ford investors might see this as a worrisome trend, which could lead them to dig even deeper into the company's history to make sure 2012 wasn't an outlier for automotive gross margin or to confirm that inventory cost inflation is eating into the company's profitability.

Investor takeawayDigging deeper into a company's accounting can enable investors to spot trends before others see them. One number worth a close look by investors in retailers, distributors, or manufacturers is the cost of goods sold, which when calculated can show key data about a company's underlying business. In the Ford example, it showed that the automaker's inventory costs in recent years inflated faster than sales, which led to lower margins.

The article How to Calculate Cost of Goods Sold originally appeared on Fool.com.

Matt DiLallo has the following options: long January 2016 $10 calls on Ford and short August 2015 $15 puts on Ford. The Motley Fool recommends Ford. The Motley Fool owns shares of Ford. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.