What Is Cost of Goods Sold (COGS)?

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What Is Cost of Goods Sold (COGS)?

Let me explain what Cost of Goods Sold, or COGS, really means. It's the direct costs tied to making or buying the products your company sells, things like materials and labor. I want you to know it doesn't include indirect stuff, such as distribution or sales team expenses. Sometimes people call it 'cost of sales,' but it's the same thing.

Why Is Cost of Goods Sold (COGS) Important?

You need to understand why COGS matters on financial statements. It's subtracted from your revenues to figure out gross profit, which shows how well a company handles its labor and supplies in production. Since COGS counts as a business expense on income statements, it helps analysts, investors, and managers predict the bottom line. If COGS goes up, net income drops, which is good for taxes but bad for shareholders. That's why businesses aim to keep COGS low to boost net profits.

What Is Included in the Cost of Goods Sold (COGS)?

COGS covers the costs of getting or making the products or finished goods that a company sells in a period. I'm talking only about costs directly linked to production, like labor, materials, and manufacturing overhead. Take an automaker, for instance: COGS would include parts and assembly labor, but not shipping to dealers or sales staff costs. Also, costs for unsold cars don't count in COGS that year, whether direct or indirect. Basically, COGS is the direct cost of goods or services customers bought that year. Ask yourself: Would this expense exist without any sales? If yes, it's not COGS. Remember, COGS only applies to costs directly related to producing goods for sale.

The Cost of Goods Sold (COGS) Formula

Here's how you calculate COGS: It's beginning inventory plus purchases during the period minus ending inventory. Sold inventory shows up on the income statement under COGS. Your beginning inventory is what's left from last year—the stuff not sold then. Add any new productions or purchases from manufacturing or retail. At year-end, subtract the unsold products from that total. That gives you the COGS for the year. On the balance sheet, inventory is under current assets, showing the ending inventory snapshot for the period.

Different Accounting Methods for COGS

The COGS value hinges on your inventory valuation method. Companies can choose from three main ones: FIFO, LIFO, or average cost, plus special identification for unique items. With FIFO, you sell the earliest purchased or made goods first. Since prices rise over time, this means selling cheaper stuff first, leading to lower COGS than LIFO and higher net income. LIFO sells the newest goods first, so in rising prices, higher costs get sold, bumping up COGS and lowering net income over time. The average cost method uses the average price of all stock, smoothing out extremes from purchases. Special identification tracks the exact cost of each unit, used for things like cars or jewels.

Companies Excluded From COGS Deduction

Many service companies skip COGS because they don't sell physical products. Under GAAP, COGS is just for inventory sold in a period. Pure service businesses have no inventory, so no COGS. If it's not on the income statement, there's no deduction. Think accounting firms, law offices, consultants—they have expenses but list 'cost of services' instead, which doesn't count as COGS.

Cost of Revenue vs. COGS

Cost of revenue applies to ongoing services, including raw materials, labor, shipping, and sales commissions. But without a physical product, you can't claim it as COGS. The IRS lists personal service businesses like doctors or painters that don't calculate COGS. Some service companies, like airlines or hotels, sell goods too—gifts, food—and they can report COGS for those inventories and deduct them.

Operating Expenses vs. COGS

Both are business expenditures, but on the income statement, operating expenses (OPEX) are separate from COGS. OPEX aren't directly tied to producing goods or services. Things like rent, utilities, office supplies, legal costs, sales and marketing, payroll, and insurance fall under OPEX, often as SG&A.

Difference Between Cost of Sales and Cost of Goods Sold

People mix these up, but cost of sales (COS) is broader. COGS is just direct costs for producing or acquiring sold goods. COS includes those plus other revenue-generating costs like direct labor and overhead, even costs to deliver to customers.

Limitations of COGS

COGS can be manipulated. Accountants might allocate too much overhead to inventory, overstate discounts or returns, alter ending inventory, overvalue stock, or ignore obsolete items. This under-reports COGS, inflating gross profit and net income. Watch for inventory buildup faster than revenue or assets to spot funny business.

How Do You Calculate Cost of Goods Sold (COGS)?

You add up direct costs for revenues, focusing on inventory or labor tied to sales. Fixed costs like rent aren't included. Inventory methods like FIFO or LIFO estimate sold value.

What Is Included in the Cost of Goods Sold?

It covers direct materials, labor, manufacturing overhead, freight (not to customers), and production costs.

Are Salaries Included in COGS?

General salaries? No. But labor directly tied to sales, like commissions, can be if connected to revenue.

How Does Inventory Affect COGS?

COGS should include all sold inventory costs, but companies estimate with FIFO or LIFO. High inventory in COGS lowers gross profit, so methods are chosen to minimize COGS for better profitability.

The Bottom Line

COGS is the direct cost of materials and labor for goods. It subtracts from revenue for gross profit, impacting the bottom line. Manage it by negotiating suppliers or improving efficiency to lower COGS and raise profits.

Key Takeaways

COGS includes all costs directly related to producing goods.
It excludes indirect costs like overhead and marketing.
COGS is deducted from sales to find gross profit; higher COGS means lower margins.
COGS varies by accounting standards.
It differs from OPEX, which aren't tied to production.

What Is Cost of Goods Sold (COGS)?

Highlights