Cost of Goods Sold (COGS) Explained & Calculation

What is cost of goods sold (COGS)?

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Table of Contents

Cost of goods sold (COGS) refers to the direct costs of producing the goods sold by a company. This amount includes the cost of both labor and materials that were utilized directly to produce the good. Indirect costs like those associated with sales force and distribution are not included.

Cost of goods sold is also referred to as “cost of sales.”

Key Takeaways

  • Cost of goods sold (COGS) includes all of the costs and expenses directly related to the production of goods.
  • COGS excludes indirect costs such as overhead and sales and marketing.
  • COGS is deducted from revenues (sales) in order to calculate gross profit and gross margin. Higher COGS results in lower margins.
  • The value of COGS will change depending on the accounting standards used in the calculation.
  • COGS differs from operating expenses (OPEX) in that OPEX includes expenditures that are not directly tied to the production of goods or services.

Why Is Cost of Goods Sold (COGS) Important?

As COGS is deducted from sales to calculate gross profit, it is a crucial indicator on financial statements. A profitability metric called gross profit assesses how well a business manages its personnel and suppliers during the production process.

COGS is included as a business expense on income statements since it is an inherent cost of conducting business. A company’s profit margin can be estimated by analysts, investors, and managers with the aid of the cost of goods sold. Net income will decline as COGS rises. The company will make less money for its shareholders despite the fact that this change is advantageous for income tax purposes. Thus, companies want to maintain low COGS in order to increase net profits.

The cost of purchasing or producing the products that a business sells over a given time period is known as cost of goods sold (COGS). As such, only expenses that are directly related to the products’ production—such as labor, material, and manufacturing overhead—are included in this figure.

For instance, an automaker’s cost of goods sold (COGS) would comprise both labor and material expenditures for the pieces that go into creating the vehicle. The price of labor employed to sell the car as well as the cost of shipping the vehicles to dealerships would not be included.

The importance of COGS

Moreover, expenses incurred for cars that were not sold during the year—whether direct or indirect—will not be factored into the computation of COGS. To put it another way, COGS comprises the actual costs incurred in manufacturing the goods or services that consumers actually bought over the year. Generally speaking, you can determine whether an expense is covered by COGS by asking yourself “Would this expense have been an expense even if no sales were generated?”

Important: COGS only applies to those costs directly related to producing goods intended for sale.

Formula and Calculation of Cost of Goods Sold (COGS)

COGS = Beginning Inventory + P − Ending Inventory

where

P=Purchases during the period

Find out more: About Form 1125-A, Cost of Goods Sold | Internal Revenue Service

Sold inventory can be found under the COGS account in the income statement. The inventory from the prior year, or the goods that were not sold, makes up the starting inventory for the current year.

A manufacturing or retail business adds any new purchases or productions to the starting inventory. The items that were unsold at the end of the year are deducted from the total of initial inventory and further purchases. The cost of products sold for the entire year is the last figure that results from the computation.

The current assets account is one of the accounts on the balance sheet. Inventory is an item under this account. A company’s financial situation is only represented on the balance sheet at the conclusion of an accounting period. This indicates that the ending inventory is represented by the inventory figure listed under current assets.

Read more: Construction Bookkeeping: A Comprehensive Guide

What Are Different Accounting Methods For COGS?

The method a corporation uses for inventory costing determines the value of the cost of products sold. A business can record the amount of inventory sold during a certain period using one of three methods: the average cost approach, last in, first out (LIFO), or first in, first out (FIFO). When dealing with expensive or rare products, the special identification approach is employed.

FIFO

First to be bought or produced are the items that are sold. A business that employs the FIFO technique will sell its least expensive products first because prices have a tendency to rise with time. This results in a lower COGS than the COGS reported under LIFO. As a result, while employing the FIFO approach, net income rises gradually.

LIFO

The most recent products added to the inventory are sold first (LIFO). Higher-cost items are sold first during price increases, which raises the COGS amount. The net income often declines with time.

Average Cost Method

The worth of the items sold is determined by averaging the prices of all the goods in stock, irrespective of the date of purchase. The smoothing effect of averaging product costs over time keeps COGS from being significantly impacted by the high or low expenses of one or more acquisitions or purchases.

Special Identification Method

The special identification technique computes the ending inventory and COGS for each period based on the unique cost of each unit of product, also referred to as inventory or goods. Using this approach, a company is able to pinpoint the particular product sold as well as its exact price. Moreover, businesses that sell distinctive goods like automobiles, real estate, and rare and valuable diamonds frequently employ this strategy.

What Type of Companies Are Excluded From a COGS Deduction?

A large number of service providers have no cost of goods sold. Generally accepted accounting rules (GAAP) do not go into great depth about COGS; nonetheless, COGS is limited to the cost of inventory items sold within a specific time frame. Service companies don’t just have no products to offer; they also don’t have any inventory. A corporation cannot deduct COGS expenses if they are not shown on its income statement.

Accounting firms, legal practices, real estate appraisers, business advisors, professional dancers, etc. are a few examples of pure service businesses. These industries don’t include COGS, despite the fact that they all incur business expenses and typically pay for their services. Rather, they have what is referred to as “cost of services,” which is not deducted from COGS.

People also read: Construction Job Costing: How to Optimize It?

Cost of Revenue vs. COGS

For continuous contract services, there are costs of revenue that can include direct labor costs, raw supplies, transportation, and commissions given to sales staff. However, in the absence of a physically manufactured product to sell, these things cannot be claimed as COGS. Even some instances of “personal service businesses” that do not include COGS in their revenue statements are provided on the IRS website. Physicians, attorneys, carpenters, and painters are a few examples.

A lot of businesses that provide services have merchandise to sell. For example, although selling presents, food, drinks, and other products, hotels and airlines are largely service providers, offering transportation and accommodation, respectively. These things are unquestionably regarded as goods, and these businesses undoubtedly have these goods in stock. COGS can be claimed for taxes and shown on income statements for each of these sectors.

Operating Expenses vs. COGS

Companies must pay both operating expenses and cost of goods sold (COGS) in order to operate their businesses; the expenses are shown separately on the income statement. Operating expenses (OPEX) are costs that aren’t directly related to the production of goods or services, in contrast to COGS.

Selling, general, and administrative (SG&A) costs are typically included separately under operational expenses. SG&A expenses are outlays that aren’t directly related to a product, such overhead costs. Some instances of running costs are as follows:

  • Rent
  • Utilities
  • Office supplies
  • Legal costs
  • Sales and marketing
  • Payroll
  • Insurance costs

What Are the Limitations of COGS?

COGS can easily be manipulated by accountants or managers looking to cook the books. It can be altered by:

  • Allocating to inventory higher manufacturing overhead costs than those incurred
  • Overstating discounts
  • Overstating returns to suppliers
  • Altering the amount of inventory in stock at the end of an accounting period
  • Overvaluing inventory on hand
  • Failing to write off obsolete inventory

Artificially inflated inventory will cause COGS to be underreported, which will raise the gross profit margin above reality and inflate net income.

When examining a company’s financial records, investors can identify dishonest inventory accounting by looking for signs of inventory growth, such as an increase in inventory that outpaces reported sales or total assets.

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

The several direct costs incurred in producing a company’s revenue are totaled to determine the cost of goods sold (COGS). Crucially, COGS is only calculated using expenses that are actually used to generate that income, like inventory held by the business or labor expenses linked to certain sales. In contrast, COGS does not account for fixed costs like electricity, rent, and management pay. One particularly significant component of COGS is inventory, which can be included in the calculation in a number of ways thanks to accounting rules.

Are Salaries Included in COGS?

COGS does not include salaries and other general and administrative expenses; however, certain types of labor costs can be included in COGS, provided that they can be directly associated with specific sales. For example, a company that uses contractors to generate revenues might pay those contractors a commission based on the price charged to the customer. In that scenario, the commission earned by the contractors might be included in the company’s COGS, since that labor cost is directly connected to the revenues being generated.

How Does Inventory Affect COGS?

The cost of all inventory sold during the accounting period ought to be included in COGS, theoretically speaking. In actuality, though, businesses frequently are unaware of the precise inventory units that were sold. To determine how much inventory was really sold during the time, they instead rely on accounting techniques like the last in, first out (LIFO) and first in, first out (FIFO) regulations. The gross profit of the business will decline if the inventory value included in COGS is comparatively high. Because of this, businesses occasionally opt for accounting techniques that will result in a lower COGS figure in an effort to increase their reported profitability.

The Bottom Line

The cost of labor and materials used to produce an item is included in the cost of goods sold, which is the direct cost of production. A company’s profits are directly impacted by COGS because it is deducted from revenue. In order to guarantee increased earnings, businesses must control their COGS. A business can increase profitability if it can lower its cost of goods sold (COGS) by negotiating better prices with suppliers or by increasing production process efficiency.

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