Cost of Goods Sold (COGS)
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Cost of Goods Sold (COGS) Definition
The cost of goods sold, or COGS, refers to any direct cost associated with the production of a product.
This includes materials, direct labor, machinery, and manufacturing overhead.
However, indirect costs, such as sales labor, transportation, and marketing, are not counted toward the cost of goods sold.
A key point when thinking about COGS is that it only applies to funds spent on producing goods that were actually sold for that period.
Inventory that is sold is recorded as a business expense on a company’s income statement under the “COGS” account.
COGS are subtracted from a company’s revenue when calculating gross profit.
It’s important to keep in mind that funds spent on producing goods that were not sold do not count towards COGS.
The cost of goods sold for a particular product is one of the metrics a company uses to determine a price for that product, along with the indirect costs.
Cost of Goods Sold (COGS) Example
For example, let’s say that to produce a ceramic coffee mug, a company has to spend approximately $2 per mug on clay, $3 per mug on the machinery required to craft it (including the electricity) and $1 to finish and paint it.
Since they have to spend a minimum of $6 just to make the mug, the selling price must be at least greater than $6 to make a profit.
The price needs to account for both COGS and any indirect additional costs like shipping and marketing.
If the same company finds a new source of clay that lets them only spend $1 on clay per mug, then the COGS gets reduced to $5 per mug.
If the quality is the same, they might sell it at the same price, and so their margin has increased.
Because of this relationship, COGS is often used as a measure of how efficiently a company is managing its labor and supplies in production.
Cost of Goods Sold (COGS) Formula
To figure out a business’s COGS for a given year, take the value of their beginning inventory, add the cost of purchases made that year, and then subtract their ending inventory.
Follow the formula:
- (BI) is the value of the Beginning Inventory
- (P)is Purchases required to produce goods, such as materials etc.
- (EI) is the value of the Ending Inventory
For example, let’s say that in the year 2019, a company started the year with $10 million in inventory, spent $8 million in purchases, and ended the year with $9 million in inventory value.
To get their COGS, take 10 + 8 – 9 to get a COGS value of $9 million.
COGS Meaning For Business
You’ll notice that the COGS of that company was equal to the value of their purchases plus the value of the inventory they sold.
However, this means that their inventory decreased, which is something management will want to pay attention to in order to manage growth and meet demand.
Often the value of purchases a company makes in a period will exceed the value of their COGS so that their inventory can grow to accommodate an increasing demand.
So long as the cost of their purchases does not exceed the profit they make from selling their product, they will not lose money by expanding their inventory.
If a company’s COGS is greater than the value of their purchases, it means that 100% of the money spent on purchases went towards products that were sold, plus the difference in inventory.
If the company’s purchases are greater than their COGS, then the difference is equal to the amount that their inventory has increased.
What Businesses Can and Can’t Record as COGS?
Because COGS is directly tied to the value of a company’s physical assets, only companies that have a physical inventory can record COGS and benefit from a deduction.
Usually, companies that can’t record COGS are pure service companies like law firms, accounting firms, etc.
Some companies can both provide services and sell products—airlines that sell food and drinks are a good example of this.
In this case, they can still record their COGS because they have an inventory to keep.