What is Cost of Goods Sold (COGS)?
Cost of goods sold (COGS) signifies the direct expenses incurred in manufacturing the goods that a company sells. This encompasses the costs of materials and labour directly utilised in the production process. Notably, it does not include indirect expenditures like distribution and sales force costs.
COGS is alternatively known as “cost of sales.”
Key points:
- COGS covers all expenses directly linked to goods production.
- It excludes indirect expenses such as overhead and sales and marketing.
- COGS is subtracted from revenues (sales) to compute gross profit and gross margin, with higher COGS resulting in lower margins.
- The COGS value varies based on the accounting standards employed.
- In contrast to operating expenses (OPEX), which encompasses costs not directly associated with goods or services production, COGS specifically pertains to production-related expenditures.
Understanding COGS
COGS stands as a pivotal metric within financial statements, as it is deducted from a company’s revenues to ascertain its gross profit. Gross profit serves as a measure of profitability, reflecting the company’s efficiency in managing labour and supplies during the production process.
Given that COGS is an integral part of business operations, it is recorded as an expense on income statements. Understanding the cost of goods sold aids analysts, investors, and managers in gauging a company’s bottom line. An increase in COGS leads to a decrease in net income. While this adjustment can be advantageous for income tax purposes, it results in diminished profits for shareholders. Hence, businesses strive to minimise their COGS to enhance net profits.
The Cost of Goods Sold (COGS) encapsulates the expenses incurred in acquiring or manufacturing the products sold by a company within a specific period. Consequently, only expenses directly associated with product production are included, such as labor, materials, and manufacturing overhead.
For instance, in the case of an automaker, COGS encompasses material costs for the car components and labour costs involved in assembly. However, expenses related to transporting cars to dealerships and sales labour are excluded.
Moreover, costs pertaining to unsold cars throughout the year are not factored into COGS, irrespective of their direct or indirect nature. In essence, COGS comprises the direct expenses linked to producing goods or services that were sold to customers during the year. To discern whether an expense falls under COGS, a useful guideline is to inquire: “Would this expense still apply even in the absence of generated sales?”
Fact: COGS pertains solely to expenses directly associated with the production of goods designated for sale.
How to calculate COGS
Cost Of Goods Sold = Starting Inventory + P − Ending Inventory
where
P = Purchases during the period
Inventory sold during the accounting period is reflected in the income statement under the COGS account. The starting inventory for the year comprises the remaining inventory from the preceding year, representing merchandise unsold during that period.
Any new productions or purchases made by a manufacturing or retail entity are added to this initial inventory. By the year’s end, the unsold products are subtracted from the total of the starting inventory and additional acquisitions. The resulting figure represents the cost of goods sold for the year.
The balance sheet features a current assets account, within which lies an entry for inventory. Since the balance sheet captures the company’s financial position at the conclusion of an accounting cycle, the recorded inventory value under current assets represents the ending inventory.
Accounting methods for COGS
The value of the cost of goods sold hinges on the inventory costing method chosen by a company. Three primary methods exist for recording the inventory sold during a given period: first in, first out (FIFO), last in, first out (LIFO), and the average cost method. Additionally, the special identification method is employed for high-value or distinctive items.
FIFO
Under the FIFO method, the earliest goods acquired or manufactured are the first to be sold. As prices generally rise over time, a company employing FIFO sells its least costly items first, resulting in a lower COGS compared to LIFO. Consequently, net income tends to rise over time when using the FIFO method.
LIFO
In contrast, LIFO involves selling the most recently acquired inventory first. During periods of inflation, this method results in higher COGS, as goods with higher costs are sold first. Consequently, net income tends to decline over time with the LIFO method.
Average Cost Method
With the average cost method, the value of goods sold is determined by averaging the cost of all inventory items, regardless of their purchase dates. This approach smooths out fluctuations in COGS caused by extreme costs from individual purchases.
Special Identification Method
The special identification method assigns a specific cost to each unit of merchandise, enabling precise calculation of ending inventory and COGS for each period. This method is particularly suitable for industries dealing with unique items such as automobiles, real estate, and rare or precious jewels.
Limitations of COGS
COGS manipulation tactics are commonly employed by accountants or managers seeking to manipulate financial records. These tactics include:
- Inflating manufacturing overhead costs allocated to inventory.
- Overstating discounts.
- Overstating returns to suppliers.
- Adjusting the reported inventory level at the end of an accounting period.
- Overvaluing inventory.
- Neglecting to write off obsolete inventory.
- Artificially inflating inventory leads to underreporting of COGS, resulting in an inflated gross profit margin and consequently, an overstated net income.
Investors scrutinising a company’s financial statements can identify dubious inventory accounting practices by observing inventory accumulation, such as inventory growth outpacing revenue or total assets reported.
FAQs
How does inventory affect COGS?
In principle, COGS is expected to encompass the cost of all inventory items sold during the accounting period. However, in practice, companies often lack precise knowledge of which inventory units were sold. Instead, they rely on accounting methodologies such as the first in, first out (FIFO) and last in, first out (LIFO) principles to estimate the value of inventory sold within the period. When the inventory value included in COGS is relatively high, it exerts downward pressure on the company’s gross profit. Consequently, companies may opt for accounting methods that yield a lower COGS figure, aiming to enhance their reported profitability.
Are salaries and other general and administrative expenses included in COGS?
COGS often excludes salaries and other general administrative expenses. However, certain labour costs can be incorporated into COGS if they are directly linked to specific sales. For instance, a company utilising contractors to drive revenue might compensate them with a commission based on the customer’s purchase price. In this case, the commission earned by the contractors could be part of the company’s COGS, given its direct association with the generated revenues.
Why does the Cost of Revenue cannot be claimed as COGS?
Costs of revenue encompass expenses related to ongoing contract services, encompassing raw materials, direct labour, shipping costs, and commissions paid to sales employees. However, these expenses cannot be classified as COGS unless there is a physically produced product available for sale.
Although many service-based companies primarily offer services like transportation and lodging, they may also sell products such as gifts, food, beverages, and other items. These goods are unequivocally considered products, and these companies maintain inventories thereof. Consequently, both industries can include COGS on their income statements and utilise them for tax purposes.
Why are Operating Expenses segregated from COGS?
Both operating expenses and cost of goods sold (COGS) represent the outlays incurred by companies in conducting their operations; however, these expenses are delineated on the income statement. Operating expenses (OPEX) comprise expenditures that are not directly linked to the production of goods or services, unlike COGS.
Often, selling, general, and administrative expenses (SG&A) are integrated into operating expenses as a distinct line item. SG&A expenses comprise overhead costs and other expenditures unrelated to a specific product. Examples of operating expenses include:
- Rent
- Utilities
- Office supplies
- Legal expenses
- Sales and marketing
- Payroll
- Insurance premiums
What type of companies are excluded from a COGS Deduction? Why?
Many service companies do not incur any cost of goods sold (COGS) whatsoever. While generally accepted accounting principles (GAAP) do not extensively address COGS, it is defined strictly as the cost of inventory items sold within a specific period. Service companies not only lack physical goods to sell but also do not maintain inventories. When COGS is absent from a company’s income statement, no deduction can be claimed for those costs.
Examples of pure service companies encompass accounting firms, law offices, real estate appraisers, business consultants, professional dancers, among others. Despite incurring business expenses and often investing in their service provision, they do not report COGS. Instead, they account for “cost of services,” which does not qualify for a COGS deduction.
Conclusion
The cost of goods sold represents the immediate expenses associated with producing a product, encompassing both material and labour costs involved in its creation. Since COGS is deducted from revenue, it significantly influences a company’s profits. Thus, companies must effectively manage their COGS to maximise profits. By securing favourable deals with suppliers or enhancing production efficiency, a company can potentially reduce its COGS, thereby increasing its profitability.
DISCLAIMER: This article serves solely for informational purposes and does not constitute official business advice.
