Cost of Goods Sold (COGS) Explained With Methods to Calculate It

What Is Cost of Goods Sold (COGS)?

Cost of goods sold (COGS) refers to the direct costs of producing the goods sold by a company. This amount includes the cost of the materials and labor directly used to create the good. It excludes indirect expenses, such as distribution costs and sales force costs.

Cost of goods sold is also referred to as "cost of sales."

Why Is Cost of Goods Sold (COGS) Important?

COGS is an important metric on financial statements as it is subtracted from a company’s revenues to determine its gross profit. Gross profit is a profitability measure that evaluates how efficient a company is in managing its labor and supplies in the production process.

Because COGS is a cost of doing business, it is recorded as a business expense on income statements. Knowing the cost of goods sold helps analysts, investors, and managers estimate a company’s bottom line. If COGS increases, net income will decrease. While this movement is beneficial for income tax purposes, the business will have less profit for its shareholders. Businesses thus try to keep their COGS low so that net profits will be higher.

What Is Included in the Cost of Goods Sold (COGS)?

Cost of goods sold (COGS) is the cost of acquiring or manufacturing the products or finished goods that a company then sells during a period, so the only costs included in the measure are those that are directly tied to the production of the products, including the cost of labor, materials, and manufacturing overhead.

For example, COGS for an automaker would include the material costs for the parts that go into making the car plus the labor costs used to put the car together. The cost of sending the cars to dealerships and the cost of the labor used to sell the car would be excluded.

Furthermore, costs incurred on the cars that were not sold during the year will not be included when calculating COGS, whether the costs are direct or indirect. In other words, COGS includes the direct cost of producing goods or services that were purchased by customers during the year. As a rule of thumb, if you want to know if an expense falls under COGS, ask: "Would this expense have been an expense even if no sales were generated?"

What Is the Cost of Goods Sold (COGS) Formula?

$\begin{aligned} &\text{COGS}=\text{Beginning Inventory}+\text{P}-\text{Ending Inventory}\\ &\textbf{where}\\ &\text{P}=\text{Purchases during the period}\\ \end{aligned}$​COGS=Beginning Inventory+P−Ending InventorywhereP=Purchases during the period​

Inventory that is sold appears in the income statement under the COGS account. The beginning inventory for the year is the inventory left over from the previous year—that is, the merchandise that was not sold in the previous year.

Any additional productions or purchases made by a manufacturing or retail company are added to the beginning inventory. At the end of the year, the products that were not sold are subtracted from the sum of beginning inventory and additional purchases. The final number derived from the calculation is the cost of goods sold for the year.

The balance sheet has an account called the current assets account. Under this account is an item called inventory. The balance sheet only captures a company’s financial health at the end of an accounting period. This means that the inventory value recorded under current assets is the ending inventory.

What Are Different Accounting Methods For COGS?

The value of the cost of goods sold depends on the inventory valuation method adopted by a company. There are three methods that a company can use when recording the level of inventory sold during a period: first in, first out (FIFO), last in, first out (LIFO), and the average cost method. The special identification method is used for high-ticket or unique items.

FIFO Method

The earliest goods to be purchased or manufactured are sold first. Since prices tend to go up over time, a company that uses the FIFO method will sell its least expensive products first, which translates to a lower COGS than the COGS recorded under LIFO. Hence, the net income using the FIFO method increases over time.

LIFO Method

LIFO is where the latest goods added to the inventory are sold first. During periods of rising prices, goods with higher costs are sold first, leading to a higher COGS amount. Over time, the net income tends to decrease.

Average Cost Method

The average price of all the goods in stock, regardless of purchase date, is used to value the goods sold. Taking the average product cost over a time period has a smoothing effect that prevents COGS from being highly impacted by the extreme costs of one or more acquisitions or purchases.

Special Identification Method

The special identification method uses the specific cost of each unit of merchandise (also called inventory or goods) to calculate the ending inventory and COGS for each period. In this method, a business knows precisely which item was sold and the exact cost. Further, this method is typically used in industries that sell unique items like cars, real estate, and rare and precious jewels.

What Type of Companies Are Excluded From a COGS Deduction?

Many service companies do not have any cost of goods sold at all. COGS is not addressed in any detail in generally accepted accounting principles (GAAP), but COGS is defined as only the cost of inventory items sold during a given period. Not only do service companies have no goods to sell, but purely service companies also do not have inventories. If COGS is not listed on a company's income statement, no deduction can be applied for those costs.

Examples of pure service companies include accounting firms, law offices, real estate appraisers, business consultants, and professional dancers, among others. Even though all of these industries have business expenses and normally spend money to provide their services, they do not list COGS. Instead, they have what is called "cost of services," which does not count towards a COGS deduction.

Cost of Revenue vs. COGS

Costs of revenue exist for ongoing contract services that can include raw materials, direct labor, shipping costs, and commissions paid to sales employees. These items cannot be claimed as COGS without a physically produced product to sell, however. The IRS website even lists some examples of "personal service businesses" that do not calculate COGS on their income statements. These include doctors, lawyers, carpenters, and painters.

Many service-based companies have some products to sell. For example, airlines and hotels are primarily providers of services such as transport and lodging, respectively, yet they also sell gifts, food, beverages, and other items. These items are definitely considered goods, and these companies certainly have inventories of such goods. Both of these industries can list COGS on their income statements and claim them for tax purposes.

Operating Expenses vs. COGS

Both operating expenses and cost of goods sold (COGS) are expenditures that companies incur with running their business; however, the expenses are segregated on the income statement. Unlike COGS, operating expenses (OPEX) are expenditures that are not directly tied to the production of goods or services.

Typically, SG&A (selling, general, and administrative expenses) are included under operating expenses as a separate line item. SG&A expenses are expenditures, such as overhead costs, that are not directly tied to a product. Examples of operating expenses include the following:

• Rent
• Utilities
• Office supplies
• Legal costs
• Sales and marketing
• Payroll
• Insurance costs

What Is the Difference Between Cost of Sales and Cost of Goods Sold?

While these terms are often used interchangeably, there's a subtle difference between the two. COGS specifically refers to the direct costs associated with producing goods or acquiring inventory that has been sold during a particular period. By contrast, COS includes not only the direct costs of goods sold but also other costs directly related to generating revenue, such as direct labor and direct overhead. Essentially, COS encompasses a broader range of expenses than COGS, as it may include additional costs associated with delivering the product or service to the customer.

What Are the Limitations of COGS?

COGS can easily be manipulated by accountants or managers looking to cook the books. It can be altered by:

• Allocating to inventory higher manufacturing overhead costs than those incurred
• Overstating discounts
• Overstating returns to suppliers
• Altering the amount of inventory in stock at the end of an accounting period
• Overvaluing inventory on hand
• Failing to write off obsolete inventory

When inventory is artificially inflated, COGS will be under-reported which, in turn, will lead to a higher-than-actual gross profit margin, and hence, an inflated net income.

Investors looking through a company’s financial statements can spot unscrupulous inventory accounting by checking for inventory buildup, such as inventory rising faster than revenue or total assets reported.

The Bottom Line

Cost of goods sold is the direct cost of producing a good, which includes the cost of the materials and labor used to create the good. COGS directly impacts a company's profits as COGS is subtracted from revenue. Companies must manage their COGS to ensure higher profits. If a company can reduce its COGS through better deals with suppliers or through more efficiency in the production process, it can be more profitable.