What Is Cost of Goods Sold (COGS)?
Cost of Goods Sold (COGS) represents the direct costs of producing goods sold by a company, which includes the costs of materials and labor directly used to create the good. It excludes indirect expenses like distribution and sales force costs.
Key Highlights
- COGS covers all costs and expenses directly related to the production of goods.
- It excludes indirect costs like overhead and marketing.
- COGS is subtracted from revenues to calculate gross profit. Higher COGS can result in lower margins.
- The value of COGS changes with the accounting standards used.
- COGS differs from operating expenses, focusing solely on the production costs.
Why Is Cost of Goods Sold (COGS) Crucial?
COGS is vital for financial statements as it is subtracted from revenues to determine gross profit. This profitability measure indicates how effectively a company manages labor and supply costs during the production process. Understanding COGS allows for predictions about the bottom line, making it crucial for analysts, investors, and managers.
Example of COGS
For an automaker, COGS includes the material costs for parts and the labor costs for assembling cars. However, it excludes costs like sending cars to dealerships or labor used in sales. Only the costs directly tied to producing the goods sold during the year are included in COGS.
Calculating Cost of Goods Sold (COGS)
The formula for COGS is:
COGS = Beginning Inventory + Purchases during the period - Ending Inventory
This formula accounts for inventory sold, appearing under the COGS account in the income statement. Details about inventory values are noted in the balance sheet under current assets.
Accounting Methods for COGS
The value of COGS varies by inventory costing methods such as FIFO, LIFO, and the average cost method.
FIFO
Earliest acquired goods are sold first, leading to a higher net income over time as older, cheaper goods are sold.
LIFO
Newest goods are sold first, tending to result in higher COGS and lower net income when prices rise.
Average Cost Method
COGS is based on the average cost of all inventory, smoothing out price variations.
Special Identification Method
Used for unique, high-value items, precision in item-specific costs is ensured.
Companies Excluded from COGS Deductions
Service companies typically don’t have COGS as they provide services rather than goods. Instead, they deal with cost of services.
Cost of Revenue vs. COGS
Service-oriented companies, even with no physical products, incur cost of revenue, covering direct labor, materials, and shipping costs related to service delivery.
Operating Expenses vs. COGS
Operating expenses (OPEX) are broader, covering costs that might not be tied directly to production, such as rent, utilities, and payroll.
Limitations of COGS
COGS can be manipulated by misrepresenting inventory values, overstating discounts, and failing to write off obsolete inventory. Vigilance in examining financial statements can reveal discrepancies.
Bottom Line
Efficiently managing COGS is fundamental for increasing a company’s profitability. By reducing COGS through meticulous cost control and supplier negotiations, companies can achieve higher net profits.
Related Terms: Gross Profit, Operating Expenses, FIFO, LIFO, Average Cost Method, SG&A.
References
- Internal Revenue Service. “Publication 535 (2021), Business Expenses”.
- Mitchell Franklin, Patty Graybeal, and Dixon Cooper. “Principles of Accounting, Volume 1: Financial Accounting”, Pages 373 and 407.
- Mitchell Franklin, Patty Graybeal, and Dixon Cooper. “Principles of Accounting, Volume 1: Financial Accounting”, Pages 652-654.
- Internal Revenue Service. “Publication 334: Tax Guide for Small Business”, Page 27.
- Mitchell Franklin, Patty Graybeal, and Dixon Cooper. “Principles of Accounting, Volume 1: Financial Accounting”, Page 405.
- Internal Revenue Service. “Publication 334: Tax Guide for Small Business”, Pages 28-29.
