COGS

What does cost of goods sold mean?

The "cost of goods sold" (COGS) is all about the direct costs involved in producing goods or services. This includes things like direct factory overheads, labour costs, and material costs. Basically, it’s directly tied to sales.

As sales revenue goes up, the cost of producing those goods or services goes up, too. You’ll often see COGS as the second item on the income statement, which is proper after-sales revenue. To figure out the gross profit, you subtract COGS from sales.

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Why is COGS important?

The main reason for calculating COGS is to figure out the "actual cost" of the goods sold during a specific period. It doesn’t include the cost of items that were bought but not sold or kept in inventory. This helps managers and investors keep an eye on how well the company is doing.

Limitations of COGS

COGS can be easily manipulated by accountants or management to make the financial statements look better. This can be done by:

  • Charging more production overhead costs to inventory than actually incurred
  • Inflating savings
  • Overstating supplier returns
  • Changing the ending inventory count
  • Overvaluing current inventory
  • Not writing off outdated inventory

How do you calculate COGS?

The formula for COGS is:
‍
COGS = Beginning Inventory + Purchases during the period (P) − Ending Inventory

Different ways to account for COGS

The amount of COGS can vary depending on how a company tracks its inventory. Here are the main methods:

FIFO (First in, first out)

With FIFO, the oldest items in inventory are sold first. Since prices usually go up over time, this method often results in lower COGS compared to LIFO, leading to higher net income.

LIFO (Last in first out)

LIFO means the newest items in inventory are sold first. In times of rising prices, this results in higher COGS and lower net income.

Average cost method

This method averages out the cost of all products in stock to determine the value of goods sold. It smooths out price fluctuations and avoids big swings in COGS.

Special identification method

This process tracks the exact cost of each item. It’s often used for high-value or unique items like cars, real estate, and rare gems.

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In short

  • COGS includes all costs directly related to making a product.
  • It does not include sales, marketing, or general overhead costs.
  • Gross profit and gross margin are calculated by subtracting COGS from sales. Higher COGS means lower margins.
  • The value of COGS can change based on the accounting methods used.
  • Operating expenses (OPEX) are different from COGS as they cover costs not directly tied to production.

In simple terms, COGS helps you understand the direct costs of making your products and how they affect your profitability.

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