Summary - Cost of goods sold (COGS) is one of the measurements used by both a small business and a large corporation to determine overall profitability. Cost of goods sold is a way to determine the direct costs that go into the production of a finished product or service. Cost of goods sold (also known as cost of sales) includes direct costs such as raw materials and direct labor expenses. In general, COGS does not include overhead costs, utility costs, marketing expenses or shipping fees. In some cases, some of these expenses can be used, but in some cases, they complicate the calculation without providing a significant benefit
COGS is used to ensure that a business is properly pricing its products to maintain a proper gross profit and gross margin. If a business does not have a sufficient gross profit they may find themselves with insufficient cash flow to cover their operating expenses. If this is the case, a business will have to find ways to reduce the cost of inventory either by finding a new supplier for their raw materials or by adjusting their labor expenses.
As part of the uniform capitalization rules, a company must capitalize their direct costs and part of their indirect costs for resale and production activities. The cost of goods sold is a way for the business to recover these costs as a COGS deduction rather than a current deduction.
We’re all familiar with the phrase, “they don’t make things the way they used to”. It’s true. There are a couple of reasons for this. First, manufacturers have come to embrace “planned obsolescence”. This is a policy where some manufacturers intentionally plan and design their products to have a relatively limited useful life. Think about it like this. Thirty to forty years ago, a young couple could buy a laundry pair (a washer and a dryer) and it would be built to last for 20 years or more. Quite possibly, it could be the only laundry pair that they would ever have to buy. While that’s great news for the couple, it’s not as great of a story for the manufacturer who is faced with the lost opportunity for additional sales. With planned obsolescence, the products are designed in such a way that (assuming general use), the product may have to be replaced in 10 or 15 years.
This brings into focus the effect of the cost of manufacturing goods and services. For example, that same washer may now use plastic for some of its key parts. This not only serves the company for their strategy of causing products to have a limited useful life, but it reduces their cost to manufacture the washer and dryer. For that young couple, they may experience this as a lower initial purchase price which would, in a perfect world, offset the idea that this will be only the first of several such products they will have to purchase in their lifetime.
For the manufacturer, the ability to produce the product for less money reduces their cost of goods sold (COGS), enabling them to have a higher profit margin on their products and a higher gross profit as a company. Since the ability of a company to make a profit is a key indicator for success, investors will tend to reward companies who have a strategy that can help them turn a profit.
In this article, we’ll take a closer look at the accounting principle behind the cost of goods sold. In addition to defining it and providing examples, we’ll review where to look for it on a company’s financial statements and some of the ways it is used in several ratios that can help determine the profitability of one company’s stock over another.
What is cost of goods sold (COGS)?
Cost of goods sold (COGS) is essentially how much it costs a business to make a sale. This is why COGS is also referred to as the cost of sales. Although most commonly used for manufacturers or for businesses, such as retail, that are highly dependent on inventory, cost of goods sold can also be used for service industries.
Cost of goods sold includes any direct expenses such as raw materials and labor that go into making a product. In some cases, it will include some overhead costs, however, this can complicate the accounting and may not provide a benefit for a business. For service-related industries, COGS will include labor costs, payroll taxes, and benefits for those individuals who are considered "billable". Cost of goods sold is generally accounted for over months, quarters, or years. It is a line item on both a company's income statement and balance sheet.
How is cost of goods sold calculated?
Cost of goods is calculated either using a perpetual inventory system or a periodic inventory system.
For most retailers, a perpetual inventory system is tied to their point-of-sale (POS) software. This makes it easy for them and in many cases automatically does the calculations that help them account for the cost of goods. Although every POS system is different, the basic steps for calculating COGS in a perpetual inventory system are:
- Compare the invoice for new merchandise to the current cost per piece in the POS system.
- “Receive” the new merchandise as an inventory component of your POS system. Be sure to include any shipping costs as “freight in” is considered to be part of COGS.
- At this point, your POS system should automatically calculate your new cost per item and automatically apply it to each sale.
For manufacturers (and retailers who don’t use a POS system), a periodic inventory system can be used. This requires businesses to make a physical calculation of their inventory. Once that’s done, the COGS can be calculated using this formula:
COGS = (Beginning inventory + Purchases during the period) – Ending inventory
For a manufacturing business, the terminology may look a little different, but the concept is the same:
COGS = (Beginning inventory + Cost of Goods Manufactured) = (Finished Goods Available for Sale – Ending Finished Goods Inventory)
So if a business has an inventory on January 1 of $100,000. During the quarter, they make additional purchases of $15,000 and they have an ending inventory of $60,000. In this case, their COGS is as follows:
COGS = (100,000 + 15,000) – 60,000
COGS = 115,000 – 60,000
COGS = $55,000
Now that you understand how the cost of goods sold is calculated, it's important to understand what it means to a business.
Why is cost of goods sold important?
Cost of goods sold is an important number that helps calculate how profitable a business is. COGS is used as part of the equation to calculate a company’s gross income:
GI = Revenues – COGS
Cost of goods sold is also used to determine pricing and business profits. For example, COGS is used by businesses to calculate the gross margin for their business. This is done by dividing a company’s gross profit by its net income to get a percentage.
In our personal financial lives, we can look at the importance of cost of goods sold by using an example of providing a cake for someone’s birthday. A person has a range of options from baking a cake from scratch to ordering a custom cake. Each of these options will become progressively more expensive in cost, but also significantly less in terms of time invested. Baking a cake from scratch may be something that can be done for pocket change using ingredients that are already at hand. However, this will also require the biggest time commitment. On the other end of the spectrum, a custom-made cake may cost several hundred dollars. This is because the baker’s time is now included as part of the direct costs involved. On the other hand, this requires the least commitment of time.
Now let’s look at this example from the perspective of the baker. Let’s say it costs them $5 in ingredients and it takes them five hours to bake and decorate your cake. If their billable rate is $20 an hour, then the direct costs to them to bake you a cake will be $105. If they are working with an assistant, that charge could be even higher. This means they have to charge you more than $105 to make a profit.
If the baker’s cost of goods sold increases. Let’s say their supplier begins to charge them more for flour or sugar, they may look to find other suppliers who can bring their direct costs down. Otherwise, they will have to either agree to make less profit or increase the cost of their goods.
We also see a good example of the cost of goods sold in our retail purchases. It’s no surprise that retailers can use their purchasing power to drive down the cost of the goods that they sell. This is called buying the goods “at cost”. But because they are in business to make a profit, they must mark up these items to help generate enough money to pay their other expenses and still generate a profit. As consumers, we understand that this is why retailers can afford to offer drastically reduced prices of 60-70% off. Although they are still making a profit, it is reduced.
How to value inventory when calculating cost of goods sold?
Like most formulas or ratios used in accounting, COGS has some subjectivity to it. That subjectivity comes from how inventory is valued. Standard accounting principles allow for three common methods to calculate the cost of goods sold: the FIFO method, the LIFO method, and the Average Cost Method.
- FIFO (First In, First Out) – This method assumes that the first inventory purchased will be the first used (or sold). FIFO is typically used by businesses (such as food and beverage companies) for perishable inventory or for inventory that is frequently rotated.
- LIFO (Last In, First Out) – This method (which has been banned except in the United States) allows businesses to apply a higher inventory cost to their merchandise, even if they are using supplies that may have cost them less. This is typically only used when a stock is not quickly replenished nor easily rotated. For example, a business that purchases clothing for $6 one month and $8 the following month, can start applying the $8 cost even though they may still be selling the inventory that only cost them $6.
- Average Cost – This is commonly used for businesses that sell many of the same items because it can smooth out any discrepancies in a FIFO or LIFO method. For this reason, it is thought to be more accurate.
Let’s look at what their COGS would be using different methods. A business buys 50 items at an $8 cost in January. In that month, they sell 40 items and buy 40 more of the same item for $10 in February.
FIFO – the business would sell all of the 50 items at the $8 before changing the valuation to the higher acquisition price.
50 x $8 = 400
40 x $10 = 400
Total Cost = $800
LIFO – the business, upon receiving the new (higher cost) order will immediately change the valuation to the higher acquisition price.
40 x $8 = 320
50 x $10 = 500
Total Cost = $820
Average Cost – the business would sell the merchandise at their respective acquisition price and average the cost.
50 x 8 = 400
40 x 10 = 400
90 at a total cost of 800 for an average cost of $8.88
If a business were to completely sell out of their inventory, there would presumably not be much difference (if any) if they used a FIFO or Average Cost method of valuation. However, since 100% inventory turnover is not a real-world scenario, you can see how the valuation could be different. It's also important to note that a business must commit to using one valuation method.
The final word on cost of goods sold
Understanding how a business calculates the cost of goods sold (COGS) and what it means to the profitability of their company is important for every investor to understand. COGS is essential to calculating the gross profit and net profit of a business. It's also important to see if a company's pricing strategy is effective.
A business will report their cost of goods sold number as one part of their income statement and balance sheet and it will be used to ensure not only accuracy in the financials that they report but also to ensure they make sound decisions as far as future pricing and profit strategies.
Cost of goods sold is generally limited to the direct costs that go into making and selling inventory. While some businesses may include some overhead costs, this can make the COGS number less accurate in either direction.
A business must choose one, and only one method for assigning a value to their cost of goods sold. These options are FIFO, LIFO, or Average Cost. Once they choose a method that is the method they will have to continue using.
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