Cost of goods sold (COGS) measures the direct costs that come from producing the goods sold by a company. COGS includes the material and labor costs that are directly used to create the good. It could also include fixed costs, such as factory overhead or storage costs. It does not, however, include indirect costs, such as distribution costs or sales force costs.
Highlights/Key Takeaways
- Cost of goods sold (COGS) refers to all of the costs and expenses directly associated with the production of goods.
- COGS excludes indirect costs, such as distribution or sales force costs.
- COGS is found on a business’s income statement and is used to calculate gross profit and gross margin.
- The calculation of COGS focuses on inventory sold during a particular time period (i.e. a given week, month, or year).
What Is Cost of Goods Sold (COGS)?
Cost of goods sold, often referred to as COGS, is a company’s direct costs of inventory sold during a given period of time. It includes the cost of materials used and labor needed that are directly related to the production of the good. Knowing the cost of goods sold gives insight into the company’s bottom line:
- If a company’s COGS increases, net income decreases.
- As revenue increases, more resources are needed to produce the goods or services.
What’s the Purpose of COGS?
COGS is an important metric for business owners and managers to track. It is subtracted from a company’s revenues in order to determine gross profit. Its purpose is to help monitor the performance of the business.
- COGS is key to assessing a business’s profitability.
- Without the cost of goods sold, it won’t be possible to get an accurate sense of expenses, revenue, and the bottom line.
What’s Included in Cost of Goods Sold?
The only costs that are included in the cost of goods sold are those that are directly related to the production of the products. Most commonly, COGS includes the cost of labor, materials, and manufacturing overhead. More specifically, it can include:
- The purchasing of items for resale (including shipping)
- The cost of raw materials needed to make or manufacture the product
- Packaging (i.e. boxes to ship orders)
- Shipping and freight costs
- Direct labor costs for making or manufacturing products
- Overhead costs (i.e. utilities from the manufacturer site)
Depending on whether your business manufactures goods or orders them for resale, the types of costs you include may differ. Regardless, only the materials, labor, and operating costs directly related to the goods should be included.
What’s Excluded from Cost of Goods Sold?
It’s important to note that not all business expenses can qualify as a cost of goods sold. If the cost keeps the business running but is not directly related to making inventory it is not included in COGS. For example, these expenses are not included:
- Office rent
- Accounting and/or legal fees
- Advertising expenses
- Distribution costs
- Non-operating expenses (i.e. interest and capital expenditures)
How Is COGS Used?
COGS is thought of as the cost of doing business, so it’s recorded as business expense on an income statement. The purpose of an income statement is to gain insight into profitability. For example, it’s used to determine the amount that a business must recover to break even before bringing in a profit.
Why Is Cost of Goods Sold Important?
Cost of goods sold is a key metric for determining overall profitability. It’s one of the most informative metrics that a business can track. COGS helps understand a business’s financial health as well as aids in:
- Making more strategic decisions
- Knowing how to price products strategically
- Effectively managing books
What Are the Limitations of COGS?
While COGS is a very important and useful metric, it’s not all-encompassing. One limitation is that it can’t effectively track changes in inventory that alter financial reports. These changes could be related to loss, theft, or damages. It’s important to do physical inventory counts to verify if your records are accurate, otherwise COGS isn’t helpful when calculated with inaccurate data. Also, COGS can easily be manipulated by accountants or managers by:
- Overstating discounts or returns to suppliers
- Altering the amount of inventory in stock at the end of the accounting period
- Not writing off obsolete inventory
- Overvaluing inventory
How to Calculate Cost of Goods Sold (COGS)
Cost of goods sold (COGS) is calculated by adding up various direct costs needed to generate the company’s revenues. The first step is to determine the time frame for which you want to know the COGS. This time period will be determined by what fits your accounting and business needs, but is often either weekly, monthly, quarterly, or annual. Next, determine the three variables needed to calculate COGS: beginning inventory, inventory costs, and ending inventory.
- Beginning inventory is the cost of goods sold for the inventory in which you started the period. For example, if the period began with 10 products that each cost $100 to make, the beginning inventory would be $1,000.
- Inventory costs refer to the costs obtained for inventory or services. These may be, direct labor, shipping costs, or product purchases. This is also sometimes called purchases in the formula.
- Ending inventory is the cost of inventory that was not sold during the period.
The last step in calculating COGS is plugging the variable costs into the standard COGS formula.
What’s the Formula for COGS?
Cost of Goods Sold Example Calculation
Let’s say that a retailer has a beginning inventory value of $10,000 recorded on January 1, 2022. Let’s also assume that at the end of the year, recorded on December 31, 2023, the ending inventory was valued at $8,000 and that throughout the year the retailer made purchases of $20,000.
Using the above formula let’s calculate the COGS for this retailer.
So, the retailer’s COGS for the year is $22,000.
Interpreting Cost of Goods Sold
So, you’ve calculated COGS but what does it really mean for your business? Interpreting COGS allows for gross profit margin and net profit to ultimately be calculated. Businesses generally try to keep their COGS lower so that net profits will be higher.
What Does Cost of Goods Sold Tell You?
COGS reveals the total direct costs of your company’s products or services sold over a certain time period. COGS tells you whether or not your business is making a profit. It can also tell you:
- What areas of your business can be cut back to make more profit
- If you need to change vendors or raise your prices to increase profit
- How to track revenue and apply for loans or financial support if needed
How to Use Cost of Goods Sold in Your Business
There is a lot that can be learned from cost of goods sold that can then be applied to your business. For example, your business won’t make money if COGS is higher than your product pricing. So be sure to track COGS to ensure profit generation. You can also use COGS in your business to find saving opportunities and avoid making cuts that harm your business. Ideally, you won’t have to sacrifice customer experience or product quality. If your business is low-margin, like a restaurant, a small difference in COGS is crucial. Even small progress of COGS will lead to higher profits.
Benefits of Cost of Goods Sold
Calculating and understanding the COGS is important to the success of your business. Benefits of COGS include:
- Allows analysts, investors, and manager to estimate the company’s bottom line
- COGS can be calculated during the time period that best matches the company’s needs
- Helps understand cash flow
- Helps manage tax liability
Drawbacks and Limitations of COGS
While important, there are drawbacks to COGS. For example, it doesn’t include costs, such as marketing and advertising, so it doesn’t show a company’s true cost of selling. Some other limitations include:
- COGS can fluctuate across time periods depending on the account method used
- COGS can easily be manipulated or falsified in the books
- COGS cannot effectively track changes in inventory
How Inventory Methods Affect COGS
The inventory recording method used will determine the value of your cost of goods sold. There are three main methods that a company can use. These can be first in, first out (FIFO); last in, first out (LIFO), and the average cost method. There is also the special identification method that is used for high-ticket or unique items. We’ll go over each method in detail.
- The FIFO method is an assessment management method where assets produced or purchased first are sold first. A company that employs the first in, first out method will sell the least expensive products first so that COGS is lower because prices often fluctuate over time. Therefore, the net income increases over time with the FIFO method.
- The LIFO method, on the other hand, assumes that the items produced or purchased last are the first items sold. During times of inflation, goods with higher costs are sold first, thus the COGS will be higher. The last in, first out method also assumes a lower profit margin.
- The average cost method is used so that the average price of all goods in stock is used to value the goods sold. Purchase date is not a factor in this method. Using the average product cost over a time period stabilizes the item’s cost and prevents COGS from being highly impacted.
- The special identification method lets businesses know exactly which item was sold and its exact cost. It uses the specific cost of each unit of merchandise to calculate the ending inventory and COGS. This method is generally used in industries that sell high-ticket or unique items, such as cars, jewels, or real estate.
Comparing COGS with Other Metrics
Cost of Revenue vs COGS
Cost of revenue exists for ongoing contract services. These services can include materials, direct labor, shipping costs, and employee commissions. However, these items can’t be claimed as COGS without there being a physically produced product to sell. The IRS gives some examples of personal service businesses that don’t calculate COGS, including doctors, lawyers, and painters.
Operating Expenses vs COGS
Operating expenses and cost of goods sold are two different expenses that companies incur while operating. The expenses are separated on the income statement. Operating expenses (OPEX) are expenses that are not directly related to the production of goods or services, unlike COGS.
Cost of Sales vs COGS
On your company’s balance sheet, you may see cost of goods sold or cost of sales listed, or sometimes both. This understandably leads to confusion, but fundamentally there is little difference between the two. Oftentimes in accounting cost of goods sold and cost of sales are used interchangeably.
Final Word
Cost of goods sold is the direct cost of producing a good. It includes the cost of materials and labor necessary to produce the goods and it directly impacts profits for your company. After calculating COGS with a standard, easy-to-use formula, a company can work to manage their COGS to ensure they reach profit goals. Understanding COGS can also allow for companies to increase efficiency in the production process, ultimately increasing profits.
