What Is Cost Of Goods Sold?

What Is Cost of Goods Sold – COGS?

Cost of goods sold (COGS) refers to the direct costs attributable to the production of the goods sold in a company. This amount would include the cost of materials used in creating the goods as well as direct labor costs used to produce those goods. What would be excluded includes indirect expenses, such as distribution costs and sales force costs.

You may also hear cost of goods sold referred to as “cost of sales.”

Inventory that is sold normally appears in your income statement under your COGS account. The beginning inventory for the year is the inventory left over from the previous year, which would be the merchandise that was not sold during the prior year. Any additional productions or purchases made by the manufacturing or retail company would be added to the beginning inventory. At the end of the year, products that have not been sold would be subtracted from the sum of beginning inventory and additional purchases. That final number from the calculation would be your cost of goods sold for that year.

Balance sheets have an account known as 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, it means that the beginning inventory is also the company’s ending inventory at the end of the previous accounting period.

What Will COGS Tell You?

There’s no question about it, COGS is an important metric on your financial statements. COGS is subtracted from a your revenue to determine the gross profit of your company. The gross profit is a profitability metric that is used to evaluate how effective a company is with managing labor and supplies production.

Since COGS is a cost of doing business, it’s recorded as a business expense on your income statements. Knowing the cost of goods sold allows investors, analysts and executives the ability to estimate a company’s bottom line. If COGS increases, net income goes down. While it’s beneficial for income tax purposes, the business will have less profit for shareholders. This is why companies try to keep cost of goods sold low so that profits will increase.

Cost of goods sold (COGS) is the cost of acquiring or manufacturing the products that a company sells during a period, so the only costs included in the measure are those that are directly tied to the production of the products, including 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.

As a rule of thumb, if you want to know if an expense falls under COGS, ask: “Would this expense have been an expense even if no sales were generated?”

Accounting Methods and COGS

There’s 3 methods that a company can use when recording the level of inventory sold during a period:

  • First In, First Out (FIFO)
  • Last In, First Out (LIFO)
  • The Average Cost Method

FIFO – The earliest goods to be purchased or manufactured are sold first. Since price points generally go up over time, companies that uses the FIFO method will sell the least expensive products first. By doing so, you get a lower COGS than the COGS recorded under LIFO. Due to this, the net income using this method would increase over the duration.

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. With this method, the net income tends to decrease over time.

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Average Cost Method – The average price of all goods in stock, regardless of what date they were purchase, would be used to value the goods sold. Taking the average product cost over a set period will usually deter COGS from being highly impacted by extreme costs.

COGS Deductions And Exclusions

A majority of service companies do not have any cost of goods sold at all. COGS is not an accepted accounting principle (GAAP), but COGS is clearly defined as only the cost of inventory items sold during any period.  If COGS is not listed on the income statement, no deduction would be applied for those costs.

Examples of pure service companies include marketing consultants, business consultants, accounting firms, law offices, real estate appraisers, professional dancers, etc. Even though all of them have business expenses and normally spend money to provide the services they offer, they don’t list COGS. Rather, they have what is called “cost of services,” but it doesn’t count toward COGS deductions.

Cost Of Revenue And COGS

Costs of revenue exist for contract services that can include direct labor, shipping costs, raw materials and commissions paid to a sales team. These items will not be able to be claimed as COGS without a physically produced product to sell.

Many service-based businesses do have some products they sell. Let’s look at a few examples. Airlines and hotels primarily provide transport and lodging respectively, but they also can sell gifts, food, beverages and books. These items are definitely considered goods and these companies have inventories of those goods. Both of these industries can list COGS on their income statements and claim them for tax purposes.

Operating Expenses And COGS

Operating expenses and cost of goods sold (COGS) are expenditures that companies incur while running their business. However, these expenses need to be segregated on your income statement. Unlike COGS, operating expenses (OPEX) are expenditures that are not directly tied to the production of goods or services. Typically, SG&A (selling, general, admin expenses) are included under operating expenses as a separate line item. SG&A expenses are expenditures that are not directly tied to a product, such as overhead costs. Examples of operating expenses include the following:

  • Renting
  • Utilities
  • Insurance costs
  • Sales and marketing
  • Office supplies
  • Legal costs
  • Payroll
  • 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
  • When inventory is artificially inflated, COGS will be under-reported which, in turn, will lead to higher than the 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.

How You Can Use COGS

As an example, let’s calculate the cost of goods sold for Company XYZ for fiscal year (FY) ended 2018. The first step is to find the beginning and ending inventory on the company’s balance sheet:

  • Beginning Inventory: Inventory recorded on the fiscal year ended 2017 = $2.72 billion
  • Ending Inventory: Inventory recorded on the fiscal year ended 2018 = $2.85 billion
  • Purchases During 2016: Using the information above = $8.2 billion

Using the COGS formula, you would get the following;

$2.72 + 8.2 – 2.85 = $8.07 billion

If we look at the company’s 2018 income statement, we see that the reported COGS is $8.07 billion.

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