This article is for educational purposes and does not constitute financial, legal or tax advice. For specific advice applicable to your business, please contact a professional.
The cost of goods sold (COGS) is a key metric for companies producing physical and/or digital goods. It is calculated using the cost of goods sold formula and recorded on a company’s profit and loss statement. Inventory (such as raw materials) will also usually be listed as current assets on the company’s balance sheet.
Examples of cost of goods sold
The most basic COGS formula is:
Value of inventory at beginning of the year + Value of any purchases made during the year - Value of inventory at end of year = Cost of goods sold
Purchases made during the period refers to anything directly related to the manufacturing of the goods.
For example, in the case of physical goods, it can include packaging, transport and wages/salaries as well as raw materials. In fact, for digital goods, labour costs often constitute a significant part of the cost of goods sold.
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COGS vs. COR and OPEX
As the name suggests, only expenses that directly relate to the manufacture of goods can be counted as part of the cost of goods sold. Indirect expenses cannot be included in COGS. They would probably be included in either cost of revenue or operating expenses.
Cost of revenue refers to expenses incurred due to the provision of a service. This service may be directly and intrinsically linked with a physical item. It is not, however, one of the direct production costs and is therefore excluded from the COGS calculation.
One common example of this would be a warranty on a physical item. The warranty is clearly only relevant if you have the physical item. The provision of warranty support, however, is not directly connected to the production of the item. This means that it cannot be included under COGS.
If the service is provided under an extended warranty, its costs will be classed under cost of revenue. If it’s provided under a standard warranty, it will probably be classed under operating expenses (OPEX).
Operating expenses are often referred to as sales, general and administrative expenses, as these tend to be the main line items in this section of the profit and loss account.
Calculating COGS depends on valuing inventory
The basic concept of cost of goods sold is very simple. Implementing it effectively in practice, however, depends on valuing your inventory accurately.
In accounting, there are three standard ways of valuing inventory. These are:
First in first out (FIFO)
Last in first out (LIFO)
Average cost method (ACM)
FIFO and LIFO both assume that products are sold in order of age. FIFO assumes that a company sells its oldest products first. LIFO assumes that a company sells its newest products first.
The reason this difference is significant is that, generally, manufacturers increase their prices over time. This means that FIFO accounting assumes that manufacturers are selling lower-priced goods before more expensive ones. LIFO assumes that they are doing the opposite.
ACM tries to get around the challenge of price inflation by taking the average value of the inventory. In principle, this can make ACM more accurate overall than either FIFO or LIFO accounting.
In practice, your choice of inventory-valuation method is probably less important than your commitment to it. Stakeholders need to be able to build up a clear picture of a business’ development from one year to the next. They can only do this if the financial accounting remains consistent.
Why cost of goods sold is important
There are two ways a company can achieve profitability. One is to maximize income and the other is to minimize its costs. Generally, stakeholders like to see companies doing both as this gives the healthiest profit margins.
Keeping track of the COGS is one way for stakeholders to measure how well a company is doing at keeping on top of its overheads. In addition to this being important on its own, it also has implications for other key measures of a company’s overall health such as its cash flow and its balance sheet.
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