In accounting, COGS appears as a line item on the company's income statement (typically below the revenue line). This amount is subtracted from the company's revenue in order to determine its gross profit. Gross profit tells the company managers and investors how much revenue they are truly earning.
The Elements of COGS
COGS is one of the fundamental costs of doing business. When a company makes a product, it must take into account how much money it took to produce the item. This helps the company to price it accordingly so that it can make profits.
Typically COGS consists of three main elements:
- Materials - The raw materials or purchased parts needed to produce the final product. If the company’s business model is to resell products, then their material cost would be the wholesale price paid to a distributor.
- Labor - The direct cost of employing workers to make the products being sold.
- Manufacturing overhead - Other miscellaneous costs involved with the direct acquisition and production of the goods being sold. Examples include factory costs, storage, trade or cash discounts, etc.
What's Not Included in COGS?
There are many other costs involved with running a business that can’t necessarily be directly attributed to the goods that it sells. These indirect costs are generally referred to as “operating expenses” and be thought of as a catchall category that is the opposite of COGS.
Some examples of operating expenses include:
- Management salaries
- Office and administrative costs
- Accounting fees
- Legal fees
Additionally, COGS also does not include those items which have not yet sold. Recall that the “S” in the acronym stands for “sold”. Instead, these are reflected as inventory on hand at the end of the period.
Example of Cost of Goods Sold
The classic example of COGS is a manufacturer that makes widgets.
Let’s imagine a scenario where for each widget sold, the company determines its costs to be:
- $25 in materials
- $10 in labor
- $5 in overhead
Therefore, the total COGS is $40 per widget.
If the company sells each widget for $50, then it will make a profit of $10 per unit.
What is the Formula for COGS?
The equation for COGS can be written as:
COGS = ( BI + P ) − EI
- BI = Beginning inventory
- P = Purchases made during the period
- EI = Ending inventory
For example, suppose your inventory costs $50,000 at the beginning of the quarter. During this time, you spend $40,000 to acquire more goods to sell. At the end of the quarter, your ending inventory of items unsold is $30,000. In this case, your COGS would be:
COGS = ($50,000 + $40,000) - $30,000 = $60,000
Accounting Methods for COGS
Because there can be a lag between when an item is produced and when it's sold, there can be some variation in the way that COGS get measured. Here are the most commonly used accounting methods for COGS:
- FIFO (first in, first out) - The earliest units to enter into inventory are counted towards the goods sold. This is also sometimes referred to as an order-of-production approach. Since costs generally tend to rise over time, this will result in the lowest COGS and higher net income.
- LIFO (last in, first out) - The last units produced are counted towards the goods sold. Assuming costs are rising, this will result in higher COGS and a lower net income.
- Average cost method - This approach blends the COGS used to produce units within the time period. This method is helpful when prices are variable and can be useful in smoothing out price fluctuations.
- Special identification method - This method accounts for each exact item used and meticulously takes it into the calculation. Specialized manufacturing facilities such as major automakers will measure COGS in this manner.
Do Service Providers Have COGS?
For most service providers where no physical items are sold, they will not have any COGS. An example of this would be an accountant. Even though they may prepare your taxes or create financial reports, these are not considered to be COGS for the accounting business. According to the IRS, the items they need for operation are considered “costs of revenue”.
The one exception is service providers who also sell products. For example, the primary business model of a movie theater is to sell tickets. However, they also offer snacks to guests such as popcorn, drinks, and candy. Those items are considered to be physical products, so their costs count as COGS for the movie theater.
How COGS are Used in Business
COGS help reveal the true cost of the products being sold. This is crucial for setting the customer price and maintaining a reasonable profit margin.
Additionally, COGS can be used to determine inventory turnover - how frequently a company replaces its inventory. Companies often use this metric as a way to plan their operations or staff their salesforce.
COGS and Income Taxes
Companies are responsible for paying taxes on the profits they earn; not their revenue. Since COGS are subtracted from revenue, they have a direct impact on how much taxes a company must pay. Therefore, it's important to ensure that they are properly categorized.
- Lower COGS will translate to higher profits and more tax
- Higher COGS will translate to lower profits and less tax
While some companies may try to manipulate their books to avoid paying too much in taxes, this is not necessarily desirable. Lower profits will mean less income for the owners and shareholders. For these reasons, it's best to report COGS as accurately as possible.
Drawbacks of COGS
Since there are several methods and variable costs involved with keeping track of COGS, it's possible for accountants or managers to manipulate its value. This might be for tax purposes or to make profits seem better than they really are.
Some examples may include:
- Including more costs to manufacturing overhead than should be allocated
- Overstating discounts
- Failing to write off obsolete inventory
While this may have some short-term benefits, the long-term repercussions are that the COGS for this period will be unreliable. As a result, the company may set unrealistic price targets or make inventory decisions under false pretenses.
The Bottom Line
Cost of goods sold is a commonly used way to capture the expenses directly involved with making the items a company sells. This metric helps the company to understand what its net revenue will be.
Because there can be several costs involved with the production of some items, there are multiple methods for measuring COGS. It's important that companies don't try to overstate or understate COGS to make their profits seem better than they are or avoid paying taxes.