What is Cost of Goods Sold?

Cost of Goods Sold Definition

Cost of Goods Sold (COGS) is a financial metric that represents the direct costs because of the production of the goods sold by a company. This figure includes the cost of the materials and labor directly used to create the product, but it excludes indirect expenses, such as distribution costs and sales force costs. COGS is a crucial metric in the calculation of gross profit, which is computed as sales revenue minus the cost of goods sold.

In accounting, companies deduct COGS from revenues (sales) to calculate gross profit or gross margin in the income statement. This measure gives insight into the efficiency of a company’s production process and its profitability.

Components of COGS

The calculation of COGS can vary depending on the accounting methods used (such as FIFO, LIFO, or average cost method) and the type of business, but it includes costs such as

• Raw material and supplies used in production
• Direct labor costs associated with the manufacturing process
• Manufacturing overhead costs directly tied to production
• The cost of purchasing goods for resale (for retailers)

Excluded from COGS are costs related to selling, general, and administrative expenses (SG&A), depreciation and amortization, and other indirect costs. Understanding COGS is essential for businesses as it affects pricing, profitability, and tax reporting.

Revenue Cost vs. COGS

Revenue Cost and COGS are different concepts in accounting:

• COGS: Represents the direct cost of the goods sold. This includes costs directly related to the manufacturing or purchasing of products, such as raw materials and labor.
• Revenue Cost: This term is not commonly used in standard accounting practices. Typically, when discussing costs related to revenue, we might refer to operating expenses or sales and marketing expenses that companies incur to generate revenue. However, these costs are not directly linked to the production of goods and are not subtracted to calculate gross profit like COGS. Instead, they are considered when calculating operating profit or net profit margin.

In short, COGS is directly tied to the production of goods sold, affecting gross profit margin, while costs related to generating revenue (often considered operating expenses) impact operating and net profit.

Operating Expense vs. COGS

Operating expenses are indirect costs not directly tied to the production of goods or services, including selling, general, and administrative expenses (SG&A), such as rent, utilities, and salaries for non-production staff.

COGS affects gross profit, while operating expenses influence operating profit.

How to Calculate Cost of Goods Sold

To calculate the Cost of Goods Sold, you can follow a basic formula that considers the inventory levels at the beginning and end of a period, as well as any purchases made during that period.

Identify the Beginning Inventory

This is the value of all the inventory you have at the start of your accounting period. Anything that can be sold, such as raw materials, work-in-progress, and finished goods, should be included in the value of all the inventory you have at the start of your accounting period. You should value them at the cost of producing or purchasing them.

Add Purchases and Other Direct Costs

Add to the beginning inventory the cost of any purchases made during the period that are directly related to the production of goods. This can include additional raw materials, direct labor (if directly involved in the production), and any other direct costs that contribute to bringing inventory to its present location and condition.

Subtract the Ending Inventory

At the end of your accounting period, count your inventory again to determine the ending inventory. It denotes the value of remaining unsold inventory. Subtracting this number from the sum of your beginning inventory and purchases gives you the COGS.

COGS Formula

The formula for calculating COGS is:

COGS = Beginning Inventory + Purchases − Ending Inventory

Calculation

Let’s say your company has the following figures for the accounting period:

• Beginning Inventory: $20,000
• Purchases during the period: $10,000
• Ending Inventory: $15,000

Using the formula, you would calculate COGS:

COGS = $20,000 + $10,000 − $15,000 = $15,000

COGS for this period amounts to $15,000.

Important Notes

• Inventory Methods: The method used to value your inventory (FIFO, LIFO, or Average Cost) can significantly affect your COGS calculation.
• Direct Costs Only: COGS should only include costs directly related to the production of goods sold. Indirect costs, such as marketing and sales expenses, do not form part of the calculation of COGS.
• Periodic vs. Perpetual Systems: The approach to managing inventory (periodic vs. perpetual) can also affect how you calculate COGS. A periodic system updates inventory balances at the end of an accounting period, while a perpetual system updates continuously as transactions occur.

Correctly calculating COGS is crucial for accurately reporting your financial performance, as it directly affects gross profit and net income.

Different Accounting Methods for COGS

In accounting, companies can use different methods to calculate the Cost of Goods Sold (COGS) depending on how they track inventory costs and determine the cost of goods when sales happen. The choice of method can significantly affect financial statements, tax liabilities, and business decisions. The three primary accounting methods used for COGS calculation are:

First-In, First-Out (FIFO)

• Description: Under FIFO, we assume that the first items added to the inventory are the first ones sold. This means the costs of the earliest goods purchased or manufactured are the first to be recognized as COGS when sales happen.
• Impact: During periods of inflation, FIFO typically results in lower COGS and higher reported profits because the older, usually cheaper, because it matches against current revenues. This can lead to higher taxes but also shows higher profitability on financial statements.

Last-In, First-Out (LIFO)

• Description: LIFO assumes that the most recently added items to inventory are the first to be sold. The costs of the latest goods purchased or manufactured are the first to be recognized as COGS.
• Impact: In times of rising prices, LIFO leads to higher COGS and lower profits because the costs associated with the most recent purchases, which are higher, are recognized first. This can cause lower taxable income and thus lower taxes, but it may also show lower profitability.

Average Cost Method

• Description: This method calculates COGS and ending inventory value based on the average cost of all items available for sale during the period. When using this method, there is no distinction made between items based on when they were purchased or manufactured.
• Impact: The average cost method smooths out price fluctuations over the accounting period, leading to more stable COGS and profits. This method finds frequent usage of businesses dealing with indistinguishable items, like commodities.

Special Considerations

• Specific Identification: Besides the major methods, businesses use the specific identification method when they can directly identify individual items. Businesses dealing with unique items (e.g., car dealerships, real estate, or high-end jewelry) commonly use this method, where they can directly identify and attribute the exact cost associated with each sold item to COGS.
• Consistency Requirement: Once a business chooses an inventory costing method, it is required to use it consistently from year to year to ensure comparability of financial statements. The financial statements must include disclosure of any change in the inventory costing method.
• Tax Regulations: In some jurisdictions, tax regulations may influence the choice of inventory costing method. If a company uses LIFO for tax in the United States, it is also required to use LIFO for financial reporting.

The choice among these methods depends on various factors, including financial, tax, and operational considerations. Businesses often choose the method that best matches their inventory turnover pattern or provides the most favorable tax or financial outcome within the bounds of the law and accounting standards.