Cost of goods sold (COGS) may be one of the most important accounting terms for business leaders to know. COGS includes all of the direct costs involved in manufacturing products. Understanding COGS, and managing its components, can mean the difference between running a business profitably and spinning on the proverbial hamster wheel to nowhere.
What is Cost of Goods Sold (COGS)?
If revenue represents the total sales of a company’s products and services, then COGS is the accumulated cost of creating or acquiring those products.
COGS is an accounting term with a specific definition under U.S. Generally Accepted Accounting Principles (GAAP) that requires product companies to apply inventory costing principles. That definition provides guidelines for which costs to include and an associated formula for calculating COGS. Most importantly, COGS is a key component of determining two critical business metrics: a company’s gross profit and its gross margin.
Gross profit is obtained by subtracting COGS from revenue, while gross margin is gross profit divided by revenue. The higher a company’s COGS, the lower its gross profit. So, COGS is an important concept to grasp.
COGS, sometimes called “cost of sales,” is reported on a company’s income statement, right beneath the revenue line.
- Understanding and managing COGS helps leaders run their companies more efficiently and more profitably.
- COGS includes all direct costs needed to produce a product for sale.
- Different inventory-valuation methods can significantly impact COGS and gross profit.
- Tax rules allow an expanded version of COGS, which can reduce tax liability.
What Is Included in Cost of Goods Sold?
COGS includes all direct costs incurred to create the products a company offers. Most of these are the variable costs of making the product—for example, materials and labor—while others can be fixed costs, such as factory overhead.
A good litmus test to determine whether something should be included in COGS is to ask: Would the cost exist if no products were produced? If the answer is no, then the cost is likely included in COGS.
Examples of costs generally considered COGS include:
- Raw materials
- Items purchased for resale
- Freight-in costs
- Purchase returns and allowances
- Trade or cash discounts
- Factory labor
- Parts used in production
- Storage costs
- Factory overhead
Exclusions From COGS
On the flip side, items that are excluded from COGS include selling, general and administrative expenses such as distribution costs to customers, office rents, advertising, accounting and legal fees, and management salaries. Logically, all nonoperating costs, such as interest and capital expenditures, are excluded from COGS, too.
Also excluded from COGS are the costs for products that remain unsold at the end of a given period. Instead, these are reflected in the inventory on hand at the end of the period.
How to Calculate the Cost of Goods Sold (COGS)
Every accountant worth her spreadsheet should be able to rattle off the basic COGS formula in her sleep. On the surface, it’s simple, comprising just three variables: beginning inventory, purchases and ending inventory. However, layers of complexity underlie each component, requiring several steps to determine their value.
Basic COGS Formula
Here’s the general formula for calculating cost of goods sold:
(Beginning Inventory + Purchases) – Ending Inventory = COGS
4 Steps to Calculate COGS
Diving a level deeper into the COGS formula requires five steps. Typically, these are tackled by accounting and tax experts, often with the help of powerful software. But these four steps are something all managers should have an appreciation for:
- Identify the beginning inventory of raw materials, then work in process and finished goods, based on the prior year’s ending inventory amounts.
- Determine the cost of purchases of raw materials that were made during the period, taking into account freight in, trade and cash discounts.
- Determine the ending inventory balance. Typically, it’s based on physical cycle counts and is done in accordance with the company’s inventory-valuation method of choice.
- Ensure that any other direct costs of production are included in the valuation of inventory.
COGS and Inventory
As evidenced by the COGS formula, COGS and inventory go hand-in-hand. For this reason, the different methods for identifying and valuing the beginning and ending inventory can have a significant impact on COGS. Most companies do periodic physical counts of inventory to true up inventory quantity on hand at the end of a period. This physical count is a double check on “book” inventory records. It also helps companies identify damaged, obsolete and missing (“shrinkage”) inventory.
Once a company knows what inventory it has, leaders determine its value to calculate the final inventory account balance using an accounting method that complies with GAAP.
Companies’ beginning inventory for the current period equals their ending inventory for the prior period, and under GAAP, purchases during each year must be recorded using accrual basis accounting.
Periodic physical inventory and valuation are performed to calculate ending inventory.
Choosing an Accounting Method for COGS
There are many different methods for valuing inventory under GAAP. Different accounting methods will yield different inventory values, and these can have a significant impact on COGS and profitability.
Here are three of the most commonly used methods for valuing inventory under GAAP:
The FIFO method assumes that the oldest inventory units are sold first. It’s an order-of-production approach. This means that the inventory remaining at the end of an accounting period would be the units that were most recently produced. During periods where costs for raw materials or labor are increasing, the FIFO method would yield a higher per-unit valuation of inventory for those items still on hand, compared with those that were sold earlier in the period. In this case, FIFO would cause COGS to be lower.
LIFO inventory valuation is a reverse-production-order approach. It assumes that the ending inventory on hand are the oldest units produced, and that the newest units produced have already been sold. During periods when costs for raw materials or labor are increasing, LIFO yields a lower per-unit valuation of inventory for those items still on hand, because they were produced earlier in the period. In this case, LIFO would cause COGS to be higher.
Average Cost Method
ACM values inventory using an average cost for the period. It blends costs from throughout the period and smooths out price fluctuations. Total costs to create products are divided by total units created over the entire period.
Examples of COGS
Consider this simplified example of COGS:
Décor.com sells high-end kitchen tables to consumers. On Jan. 1, 2019, it held five tables in inventory, each valued at $1,000. Then, during the year, Décor purchased 10 additional tables from its supplier. On Dec. 31, 2019, Décor counted three unsold tables in its warehouse.
Here’s how the company would calculate its costs:
(Beginning Inventory + Purchases) – Ending Inventory = COGS
So, in Décor’s case:
|- Ending Inventory||3,000|
|= Cost of Goods Sold||$12,000|
How Is COGS Different From Cost of Revenue and Operating Expenses
Several other accounting concepts are similar to COGS, but each is different in its own way. Two of the most commonly confused terms are “cost of revenue” and “operating expenses.”
Here’s how they differ:
Cost of revenue vs. COGS:
Cost of revenue is most often used by service businesses, although some manufacturers and retailers use it as well. Cost of revenue is more expansive than COGS; it includes not only all the COGS components, but also direct costs in the sales function, such as sales commissions, sales discounts, distribution and marketing. Similar to COGS, cost of revenue excludes any indirect costs, such as manager salaries, that are not attributed to a sale.
Operating expenses vs. COGS:
“Operating expenses” is a catchall term that can be thought of as the opposite of COGS. It deals with the costs of running a business, but not necessarily the costs of producing a product. Operating expenses include selling, general and administrative (SG&A) expenses such as insurance, legal and accounting fees, travel, taxes and office supplies. Excluded from operating expenses are COGS items as well as nonoperating expenses, such as interest and currency exchange costs.
What Does Cost of Goods Sold Tell You, and Why is it Important?
Subtracting COGS from revenue gives gross profit, which reveals the core essence of business viability: What are my costs to make a product, and how much do I sell it for?
How to Use Cost of Goods Sold for Your Business
Properly calculating COGS shows a business manager the true cost of the products sold. This is critical when setting customer pricing to ensure an adequate profit margin.
In addition, COGS is used to calculate several other important business management metrics. For example, inventory turnover—a sales productivity metrics indicating how frequently a company replaces its inventory—relies on COGS. This metric is useful to managers looking to optimize inventory levels and/or increase salesforce sell-through of their products.
COGS is also used to determine gross profit, which is another metric that managers, investors and lenders may use to gauge the efficiency of a company’s production processes.
Drawbacks and Limitations of COGS
Because a COGS calculation has so many moving parts, it can be prone to errors and subject to manipulation. An incorrect COGS calculation can obscure the true results of a business’ operations. It can also result in misstated net income and tax liability.
At the very least, this can lead to wasted time and lost opportunities. At worst, there can be ethical and legal implications.
Cost of Goods Sold and Tax Returns
So far, this discussion of COGS has focused on GAAP requirements, but COGS also plays a role in tax accounting. Businesses that hold physical inventory—such as manufacturers, retailers and distributors—are required to calculate COGS when determining their taxable income.
This tax calculation of COGS includes both direct costs and parts of the indirect costs for certain production or resale activities as defined by the uniform capitalization rules. Indirect costs to be included for tax purposes include rent, interest, taxes, storage, purchasing, processing, repackaging, handling and administration. For detailed worksheets, see IRS Publication 334; for most managers, however, it’s sufficient to understand that this expanded calculation of COGS typically decreases the total tax bill.
For businesses with under $25 million in gross receipts ($26 million for 2020), there are some exceptions to the rules for inventory, accrual accounting and, by extension, COGS.
Cost of Goods Sold and Accounting Software
Calculating COGS can be challenging. It requires a company to keep complete and accurate records for the GAAP calculations reported on financial statements and, separately, to support a tax return. A company’s inventory management, from both the physical and valuation perspectives, must be precise. Purchases and production costs must be tracked during the year.
And regardless of which inventory-valuation method a company uses—FIFO, LIFO or average cost—much detail is involved.
All of the above can become exponentially more complicated when volumes and product lines increase. For companies with many SKUs, the best approach to calculating COGS will be a robust accounting system that’s tied to inventory management.
However you manage it, knowing your COGS is critical to achieving and sustaining profitability, so it’s important to understand its components and calculate it correctly. COGS also reveals the true cost of a company’s products, which is important when setting pricing to yield strong unit margins.
Calculating COGS can be challenging, especially as the business becomes more complex; an accounting system integrated with inventory management software can reduce the effort required and ensure accuracy.