Cost Of Goods Sold (COGS): A Simple Explanation

Profits can only be calculated properly with all the costs in mind. Cost of Goods Sold (COGS) is a widely adapted phrase that millions of accountants use across the globe to keep accurate track of the expenses their business had to pay to produce its offering—find out why COGS is efficient and how to calculate it with the practical examples below.

What Is COGS, Or Cost Of Goods Sold?

Main Takeaways

• All costs and expenses directly associated with creating goods are included in the cost of goods sold (COGS).
• Indirect expenses like sales and marketing, and overhead are not included in COGS.
• Gross profit and gross margin are determined by deducting COGS from revenues (sales).
• Lower margins are the result of higher COGS.
• Depending on the accounting principles (FIFO/LIFO) employed in the computation, COGS will have a different value.
• Operating expenses (OPEX) are distinct from COGS since OPEX covers costs that are not directly related to the creation of goods or services.

Understanding Cost of Goods Sold (COGS)

Due to the fact that COGS is deducted from revenues to calculate gross profit, it is a crucial financial statement indicator. Gross profit is a measure of profitability that assesses how effectively a business manages its workers and resources during the production process.

COGS is accounted for on the income statements, namely as a business expense.

Analysts, investors, and managers can predict the company's bottom line with the help of the cost of products sold.

Net income will go down if COGS rises. Although this change is advantageous for tax considerations, the company will make less money for its owners. Therefore, companies work to keep their COGS low in order to increase their net profits.

The only costs included in the metric are those that are directly related to the production of the goods, such as the cost of labor, materials, and manufacturing overhead. Cost of goods sold (COGS) is the cost of purchasing or making the things that a company sells during a period.

Read more about Revenue vs. Income.

For instance, COGS for a bike maker would include the labor expenses necessary to assemble the bike as well as the material prices for the parts that go into creating the bike. Costs associated with transporting the vehicles to dealerships and hiring salespeople would be excluded.

Additionally, whether the costs are direct or indirect, they will not be taken into account when computing COGS for the bikes that were not sold during the year.

In other words, COGS covers the direct expenses associated with producing the products that customers purchase during the year. Ask yourself: "Would this expense have happened even if no sales were generated?" as a general rule to determine if an expense qualifies as COGS.

Cost of Goods Sold Calculation Formula (COGS)

Beginning Inventory + P - Ending Inventory = COGS

Inventory that is sold is recorded on the income statement under the COGS account, where P = Purchases made during the period. The stock that was left over from the prior year, or the goods that weren't sold, serves as the beginning inventory for the next fiscal year.

A manufacturing or retail business must include any further acquisitions or productions in its beginning inventory. The products that weren't sold are deducted from the total of the initial inventory and new purchases at the end of the year. The cost of products sold for the entire year is the final result of the computation.

A company's financial situation is only depicted on the balance sheet at the end of an accounting period. This indicates that the ending inventory is the amount that is recorded under current assets.

COGS and Accounting Techniques

The inventory costing method a corporation uses will determine the amount of cost of goods sold. Last in, first out (LIFO), first in, first out (FIFO), and the average cost method are the three techniques a business might use to record the amount of inventory sold during a period. For expensive or one-of-a-kind products, a specific identification procedure is used.

FIFO (First In, First Out) Simply Explained

The earliest manufactured or purchased commodities are sold first. A business that employs the FIFO approach will sell its least expensive products first because prices have a tendency to rise with time, which results in lower COGS than the COGS reported using the LIFO method. As a result, when adopting the FIFO method, the net income grows over time.

LIFO (Last In, First Out) In Simple Words

The latest items added to the inventory are sold first under the LIFO system. Products with higher costs are sold first in rising price periods, which raises COGS. The net income typically declines over time. LIFO is generally not accepted during official reporting.

Average Cost Approach

The worth of the sold goods is calculated using the average cost of all the items in stock, regardless of when they were purchased. The smoothing effect of averaging the cost of a product over time prevents COGS from being significantly impacted by the high costs of one or more acquisitions or purchases.

How Is Cost of Goods Sold (COGS) Calculated?

The different direct costs necessary to produce an organization's revenues are added together to determine cost of goods sold (COGS). It's important to note that COGS only considers expenses that were directly incurred in generating that income, such as the cost of the company's inventory or labor expenses that could be linked to specific sales.

In contrast, COGS does not account for fixed expenses like managerial salaries, rent, and utilities. Because inventory plays a significant role in COGS, accounting regulations allow for a variety of methods to include it in the computation.

Cost of goods sold (COGS) is an essential aspect of every business, both for tax and profitability reasons. Accountants who know exactly how to record COGS rise above those who struggle with this essential area, so studying the above multiple times is vital for success. Curious to see how proper expense accounting can further enhance your results? Check out one of our related articles now—see you there!