Costs of Goods Sold. Definition | Calculation | Example

Cost of Goods Sold (COGS) is the direct cost of producing or acquiring the goods and services sold by a company; This includes the cost of materials, labour, and overhead. To calculate COGS, you need to know how much it costs your business to produce each unit of product or service. In this blog post, we will discuss what COGS is and how to calculate it for your business.

What is the Cost of Goods Sold?

Every business makes something or provides a service to customers (or both). The direct costs associated with this activity are recorded in your income statement's 

The cost of goods sold (COGS) is the direct cost of producing a good or service. COGS measures a company's "direct hit" on its bottom line when it produces goods or services. 

By extension, COGS also encompasses the business' BOM (bill of materials), work in progress (WIP), and finished goods inventory levels at any given time. 

COGS includes the cost of materials and labour directly expended on creating a product. It excludes indirect expenses, such as shipping and administration. 

In simple terms, COGS is calculated by taking the beginning inventory levels, adding purchases made during a period and reducing closing inventory levels.

The purpose of calculating COGS is to evaluate the profitability of a company's product. By subtracting COGS from revenue, you can calculate gross profit. You can refine your calculation by factoring in other expenses to determine net profit. 

For a retailer, COGS is the cost of buying and acquiring the goods it sells to its customers. For a manufacturer, COGS is the cost of purchasing the raw materials and manufacturing its finished products. COGS is also a key feature on an income tax return and an essential consideration in computing income taxes.

Why is the cost of goods sold important?

• COGS is used to calculate a company's gross profit. Gross profit is an essential measure of a company's financial performance. It is calculated by subtracting the cost of goods sold from the company's revenue. This measure tells us how much money the company has earned after accounting for the costs associated with producing its products or services.
• In addition, the cost of goods sold is used to assess a company's pricing strategy and whether or not the prices for the company's products align with the costs of producing those products.

How is the Cost of Goods Sold calculated?

The cost of goods sold is calculated by taking the beginning Inventory of products, plus the acquisitions of new products during the period, minus the ending Inventory. It's important to note that COGS does not include marketing or administrative costs.

Cost of Goods sold formula.

COGS = Opening Inventory + Purchases - Closing Inventory

For example, if a company begins the year with $10,000 worth of products and buys an additional $15,000 worth of products during the year, but ends up with $8,000 value of products at the end of the year, then:

COGS = 

$10,000 (beginning inventory) + $15,000 (acquisitions) - $8,000 (ending inventory) = $17,000 (cost of goods sold)

Is the cost of goods sold the same as gross profit?

The cost of goods sold (COGS) is not the same as gross profit. COGS reflects the direct costs incurred in producing the goods or services sold during a period. In contrast, gross profit reflects a company's total revenue minus its COGS. Thus, gross profit represents the portion of a company's sales that exceeds its direct production costs and provides a better indication of pure profit margins.

Is it true that EBITDA = Revenue - Cost of goods sold?

There are a few different formulas that can be used to calculate EBITDA, but the most common is Revenue - Cost of goods sold - Expenses. This particular formula is often used when calculating a company's earnings before interest, taxes, depreciation, and amortization.

EBITDA is an important measure for companies because it represents their true operating performance without the impact of these four factors. By stripping out the effects of interest, taxes, depreciation, and amortization, EBITDA provides a more accurate depiction of a company's profitability.

Presentation of COGS in Financial statements in USGAAP

Both U.S. GAAP and IFRS contain neither a formal definition of cost of goods sold (COGS) nor a requirement that companies separately present COGS on their financial statements. 

Companies following Generally accepted accounting principles GAAP must comply with accounting and disclosure guidance under ASC Section 705, Cost of Sales and Services (Financial Accounting Standards Board [FASB] 2015d), and ASC 330, Inventory. Although the primary basis of accounting for Inventory is cost with complete absorption of fixed overhead, GAAP permits companies many variations when reporting COGS. For example, a company may include outbound shipping and handling costs in COGS (FASB 2015c, Revenue Recognition, ASC 605-45-50-2), or a company may choose to exclude not only shipping and handling charges but also depreciation and amortization costs. The flexibility allowed in reporting COGS makes the inter-company and inter-industry comparison of COGS challenging.

Heres an example of YoY disclosure of Cost of Goods sold in an annual income statement

Why do we not include selling expenses in COGS?

The cost of goods sold (COGS) is the total cost of purchasing and producing the Inventory that a company sells during a given period. On the other hand, selling expenses are all the costs associated with running the sales and marketing side of the business. Because selling expenses are not directly related to producing or acquiring Inventory, they are not included in COGS. 

Selling expenses like advertising, commissions, and shipping fees are deducted from gross sales to get net sales.

Summary: 

COGS is an essential metric for business owners to understand because it represents the direct cost of producing or acquiring the goods and services sold by a company. To calculate COGS, you need to know how much it costs your business to produce each unit of product or service. We hope this blog post has helped you better understand what COGS is and how to calculate it for your business. Please read our other blog posts in this series for more information on accounting basics.