What is the Cost of Goods Sold (COGS)?
The cost of goods sold (COGS) is the cumulative total direct costs incurred with respect to the goods or services sold and includes direct expenses like the cost of raw material, direct labor cost and other direct expenses but excludes all the indirect expenses incurred by the company.
It is the cost that is directly related to the production of the goods sold in a company. In other words, COGS is the accumulation of the direct costs that went into the goods sold by your company. This amount includes the cost of any materials used in the production of the goods and also includes the direct labor costs used to produce the said well. Labor costs include direct labor and indirect labor.
- Costs of materials include direct costs like raw materials, as well as supplies and indirect materials. Where non-incidental amounts of supplies are maintained, the taxpayer must keep inventories of the supplies for income tax purposes, charging them to expense or goods sold as used rather than as purchased.
- Direct labor costs are the wages paid to those employees who spend all their time working directly on the product being manufactured. Indirect labor costs are the wages paid to other factory employees involved in the production. Costs of payroll taxes and fringe benefits are generally included in labor costs but may be treated as overhead costs.
- It excludes indirect expenses such as Sales Cost or Marketing costs. In the income statement presentation, the goods sold is subtracted from net revenues to arrive at the gross margin of a business.
- In the service industry, this would include payroll taxes, labor, and benefits for employees who are directly involved in providing the service. Any costs associated with indirect expenses are excluded from the COGS, such as marketing expenses, overhead, and shipping fees.
- For example, of the cost for a Laptop, the maker would include the costs of material required for the parts of the Laptop plus the labor costs used to assemble the parts of the Laptop. The cost of sending the laptops to dealers and the cost of the labor incurred to sell the laptops would be excluded. Also, costs incurred on the laptops that are in stock during the year will not be included when calculating the Cost of Goods sold, whether the costs are direct or indirect. In other words, These include the direct cost of producing goods or services that are sold to the customers during the year.
Impact of Inventory Method
It can also be impacted by the type of costing methodology used to derive the cost of ending inventory. There are one of three methods of recording the cost of inventory during a period – First In, First Out (FIFO), Last In, First Out (LIFO), and Average Cost Method.
Consider the impact of the following inventory costing methods:
- First in, first-out method – Under this method, known as FIFO Inventory, the first unit added to the COGS inventory is assumed to be the first one used. In an inflationary environment, where prices are increasing, FIFO results in the charging of lower-cost goods to the COGS.
- Last in, first-out method – Under this method, known as the LIFO Inventory, the last unit added to the cost of goods sold inventory is assumed to be the first one used. In an inflationary environment where prices are increasing, LIFO results in the charging of higher-cost goods to the cost.
- Average Cost Method – The average cost is calculated by dividing the total cost of goods ready for sale by the total number of units ready for sale. It gives a weighted-average unit cost that is applied to the units available in closing inventory at the end of the period.
Example of Cost of Goods Sold
Cost varies depending on whether the business is retail, wholesale, manufacturing, or service business.
- In retailing and wholesaling, COGS during the reporting period involves beginning and ending inventories. It, of course, includes purchases made during the reporting period.
- In manufacturing, it involves finished-goods inventories, plus raw materials inventories, goods-in-process inventories, direct labor, and direct factory overhead costs.
- In the case of service business, revenue is being derived from the activities of individuals rather than product sales. Hence calculating the cost of goods sold is a smaller task due to the low-level use of materials required to earn the income.
Importance of COGS
COGS is an important component of the financial statements. It is deducted from the company’s revenues to arrive at gross profit. The gross profit is a measure that evaluates how effectively the company is managing its operating cost in the production process. Cost of Goods Sold used by analysts, investors, and managers to forecast the company’s gross profit. If COGS increases, gross profit will decrease and visa versa. Businesses, therefore, will able to keep their COGS low so that the net profits will be higher.
COGS may be used internally to measure the company’s success and to determine when prices on a particular product need to be increased. The goods sold can also be used to set profit margins and as the basis of your product’s price.
Limitations of COGS
It can easily be adjusted by allocating to inventory higher manufacturing costs than was incurred, adjusting the amount of inventory in closing stock at the end of an accounting period, overvaluing inventory in stock, failing to write-off outdated inventory, etc. When the cost of inventory is purposefully inflated, COGS will be reduced, which, in turn, will lead to higher than the actual gross profit margin, and hence, an inflated net income.
Cost of Goods Sold Video
This article has been a guide to the Cost of Goods Sold and its definition. Here we discuss how to calculate COGS and how inventory valuation methods impact the same. You may also have a look at these articles below to learn more about Accounting –