Cost of goods sold (COGS) is the total value of direct costs related to producing goods sold by a business. Apart from material costs, COGS also consists of labor costs and direct factory overhead.
Direct factory overhead refers to the direct expenses in the manufacturing process that includes energy costs, water, a portion of equipment depreciation, and some others. COGS takes into account only direct expenses, so indirect expenses like marketing and administration costs are not included.
Note that not all businesses have COGS listed on their income statement. Companies that are fully service-based such as consultant and lawyer businesses do not have inventory or goods to sell. Yet, these companies still have direct expenses to provide their services. Thus, these types of expense often called “Cost of Services” instead of COGS, both of them are different.
As a side note, COGS is often named as “cost of sales” with both having the same formula. Some people may have a hard time differentiating COGS with other indicators such as Operating Expenses and Revenue Cost. Revenue Cost refers to COGS plus shipping costs and sales commissions. Basically, revenue cost also takes into account direct cost outside of the company. In a different circumstance, Operating Expenses are indirect costs related to the production of goods. Some of the examples include selling, general, & administrative (SG&A) cost and taxes. Bots operating expenses and COGS are listed as expenses on the income statement.
Cost of Goods Sold Formula
Inventory is the goods or assets intended for sales, including raw materials. The inventory account is a part of current assets and usually appears under the COGS on the income statement. The beginning inventory refers to the value of inventory owned by a company in the beginning year or quarter (depending on the period used to calculate COGS). To determine the value of beginning inventory, you can simply look at the end value of inventory from the previous term.
Intuitively, we can say that the ending inventory is the remaining inventory at the end of the period. In other words, ending inventory is the leftover goods that haven’t left the company or haven’t been sold. The last variable is “Purchases”, which refers to the additional purchase or production made during the period. To put it simply, it’s the costs to fill the inventory during that time.
Even if the amount of beginning inventory, ending inventory, and purchases are the same, the value of COGS may differ depending on the costing method used by the company. There are 3 generally approved methods when recording the cost of sold inventory: FIFO (First In, First Out), LIFO (Last In, First Out), and the Average Cost.
FIFO method is adopted when the company sells the earliest made or purchased goods first instead of the latest. Due to inflation, prices are inclined to increase over time. In that case, the earlier a product comes in as an inventory, the cheaper it will be, making the value of COGS to be lower. Contrarily, LIFO is used when the company sells last-added goods first. This method will make the value of COGS to be higher compared to the figure under FIFO.
On the other hand, The Average Cost method (like its name) takes the average cost of goods from the period as the value of inventory. This method smooths the value of COGS regardless if the company sells its earliest or latest goods, while also preventing COGS to be overly impacted by prices volatility.
Cost of Goods Sold Example
A toy company had released its financial statements for 2019. On the balance sheet, we can see that the value of leftover inventory is $500,000. In the previous year of 2018, the company has an ending inventory of $550,000. Furthermore, the production value made during that year is calculated to be $1,500,000. What is the COGS of the company?
Let’s break it down to identify the meaning and value of the different variables in this problem.
- Beginning Inventory = 500,000
- Ending Inventory = 550,000
- Purchases = 1,500,000
Now let’s use our formula and apply the values to our variables to calculate the cost of goods sold:
In this case, the cost of goods sold would be $1,450,000.
From the result, we can see that the toy company’s direct cost of sold goods for the year 2019 is $1,450,000. This value should be the same as COGS reported on the company’s 2019 income statement. Keep in mind that the costing method adopted by the company affects the value of COGS. Different methods may yield different results.
Cost of Goods Sold Analysis
Cost of Goods Sold is an essential metric mainly to determine the value of gross profit, which is total revenue—or sales—subtracted by COGS. By calculating gross profit, we can see how effective and efficient the company is in using its direct resources to get a satisfactory profit. To get a more concrete view, we can divide the value of gross profit with the initial total revenue to get the figure of gross profit margin. Gross profit margin is a ratio that gives us the percentage of how much the proportion of revenue exceeds the COGS.
Another important thing to note is that the cost of goods sold does not include goods that are not sold during the period. Pay attention to the word “sold”. So, even if a product is made, it doesn’t mean the production cost will automatically be included in the total COGS.
Recall that we also mention various methods in calculating COGS which may give numerous results. COGS is one of the components used to determine net income. Subsequently, the value of net income decides the amount of income tax needed to be paid by the company. By decreasing the value net income, it also lessens the tax payment burden. Still, lower net incomes also mean lower value of dividends shared to the stockholders. Thus, whether to keep the value of COGS high or low depends on each business discretion.
Unfortunately, this aspect is also the reason why COGS manipulation sometimes happens. By artificially altering the value of COGS, the company valuation may rises do to the inflated income. Investors can have a wrong evaluation of the company if such cases take place.
Cost of Goods Sold Conclusion
- The cost of goods sold is the direct costs to produce goods sold by a business.
- The formula for Cost of Goods Sold requires three variables: Beginning Inventory, Purchases, and Ending Inventory.
- The value of COGS may differ depending on the costing method the company adopts (FIFO, LIFO, or Average Cost). This is the case even if the amount of beginning inventory, ending inventory, and purchases are the same.
- COGS is an important variable to determine the value of gross profit and gross profit margin.
- Not all direct costs to produce goods are included in COGS, only the direct costs that ultimately become sold goods are incorporated.
Cost of Goods Sold Calculator
You can use the cost of goods sold calculator below to quickly calculate the direct costs to produce goods sold by a business by entering the required numbers.
1. What is Cost Of Goods Sold (COGS)?
The cost of goods sold (COGS) is the direct cost to produce goods sold by a business. This includes the costs of the materials, labor, and overhead used to manufacture the products that are then sold to customers.
2. How do we calculate the Cost Of Goods Sold (COGS)?
The calculation of the cost of goods sold (COGS) is done by taking the beginning inventory, plus the purchases, minus the ending inventory. This will give you the total amount of COGS for the period.
3. Are Salaries Included in Cost Of Goods Sold (COGS)?
Salaries are not included in the calculation of COGS. COGS is only for the direct costs to produce goods that are sold. Salaries are considered an indirect cost and are not part of the cost of goods sold.
4. What items are included in Cost Of Goods Sold (COGS)?
The cost of goods sold (COGS) includes the costs of the materials, labor, and overhead used to manufacture the products that are then sold to customers. This does not include salaries, administrative costs, or any other indirect costs.
5. What is the difference between Cost Of Goods Sold (COGS) and operating expenses?
The difference between COGS and operating expenses is that COGS is for the direct costs to produce goods that are sold, while operating expenses include all the company's expenses, both direct and indirect. Operating expenses are used in the calculation of net income.