What is ‘Cost of Goods Sold – COGS’
Cost of goods sold (COGS) is the direct costs attributable to the production of the goods sold in a company. This amount includes the cost of the materials used in creating the good along with the direct labor costs used to produce the good. It excludes indirect expenses such as distribution costs and sales force costs.
Cost of goods sold is also referred to as “cost of sales.”
BREAKING DOWN ‘Cost of Goods Sold – COGS’
Cost of goods sold (COGS) is the cost of acquiring or manufacturing the products that a company sells during a period. Therefore, the only costs included in the measure are those that are directly tied to the production of the products, such as the cost of labor, materials, and manufacturing overhead.
For example, the COGS for an automaker would include the material costs for the parts that go into making the car plus the labor costs used to put the car together. The cost of sending the cars to dealerships and the cost of the labor used to sell the car would be excluded. Furthermore, costs incurred on the cars that were not sold during the year will not be included when calculating COGS, whether the costs are direct or indirect. In other words, COGS includes the direct cost of producing goods or services that were purchased by customers during the year.
Calculating the Cost of Goods Sold – COGS
Inventory that is sold appears in the income statement under the COGS account. To calculate the cost of goods sold during the year, this formula is used:
COGS = Beginning Inventory + Purchases during the period – Ending Inventory.
The beginning inventory for the year is the inventory left over from the previous year, that is, the merchandise that was not sold in the previous year. Any additional productions or purchases made by a manufacturing or retail company are added to the beginning inventory. At the end of the year, the products that were not sold are subtracted from the sum of beginning inventory and additional purchases. The final number derived from the calculation is the cost of goods sold for the year.
The balance sheet has an account called the current assets account. Under this account is an item called inventory. The balance sheet only captures a company’s financial health at the end of an accounting period. This means that the inventory value recorded under current assets is the ending inventory. Since the beginning inventory is the inventory that a company has in stock at the beginning of its accounting period, then this means that the beginning inventory is also the company’s ending inventory at the end of the previous accounting period.
Impact on Cost of Goods Sold – COGS
The value of the cost of goods sold depends on the inventory costing method adopted by a company. There are one of three methods that a company must use when recording the level of inventory sold during a period – First In, First Out (FIFO), Last In, First Out (LIFO), and Average Cost Method.
- FIFO – The earliest goods to be purchased or manufactured are sold first. Since prices tend to go up over time, a company that uses the FIFO method will sell its least expensive products first, which translates to a lower COGS than the COGS recorded under LIFO. Hence, the net income using the FIFO method increases over time.
- LIFO – The latest goods added to the inventory are sold first. During periods of rising prices, goods with higher costs are sold first, leading to a higher COGS amount. Over time, the net income tends to decrease.
- Average Cost Method – The average price of all the goods in stock, regardless of purchase date, is used to value the goods sold. Taking the average product cost over a time period has a smoothing effect that prevents COGS from being highly impacted by extreme costs of one or more acquisitions or purchases.
Importance of Cost of Goods Sold – COGS
The COGS is an important metric on the financial statements as it is subtracted from a company’s revenues to get its gross profit. The gross profit is a profitability measure that evaluates how efficient a company is in managing its labor and supplies in the production process.
Because cost of goods sold is a cost of doing business, it is recorded as a business expense on the income statements. Knowing the cost of goods sold helps analysts, investors, and managers estimate the company’s bottom line. If COGS increases, net income will decrease. While this movement is beneficial for income tax purposes, the business will have less profit for its shareholders. Businesses, therefore, try to keep their COGS low so that net profits will be higher.
Limitations of Cost of Goods Sold – COGS
The 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 was actually 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; etc. When inventory is artificially inflated, COGS will be underreported which, in turn, will lead to higher than actual gross profit margin, and hence, an inflated net income.
Investors looking through a company’s financial statements can spot unscrupulous inventory accounting by checking for inventory buildup, such as inventory rising faster than revenue or total assets reported.