The income statement in a set of financial statements can give a good insight into the profitability and performance of a company over a period of time. It shows what is bringing money and what is costing money.
A key element of the income statement besides revenues is the cost of goods sold, often referred to as COGS. Without COGS, there would be no revenue so let’s dig into the basics of COGS.
Cost of Goods Sold: Defined and Explained
Cost of goods sold or COGS includes any cost associated with making a product that a company will sell to generate revenue. It usually includes any cost for raw materials or direct labor used for production. Think of anything directly related to production.
COGS will exclude operating expenses and general administrative expenses or indirect expenses. For example, marketing costs, rent, utilities or administrative employees’ salaries.
The main thing to think about when identifying a COGS is to ask yourself whether the expense will be generated regardless of the sale. If it is, then chances are it’s not classified as COGS.
Taking rent and utilities as an example, it doesn’t matter if you sell goods or not, those expenses need to be paid to the landlord and the utilities companies for the business to keep on operating. As such, rent or utilities would not be included in COGS.
COGS is very specific to companies where core activities are to sell goods. If a company is operating in the service industry, there will not be any cost of goods sold in the income statement.
For example, professional services firms such as accounting or law firms do not operate by producing goods but rather earn income by providing services to customers using their human capital.
Service companies, can have a category called cost of services where those costs would typically comprise staff salaries.
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How to Calculate Cost of Goods Sold
Cost of goods sold can be the determining factor on whether a company is profitable or not since we deduct COGS from revenues to get to gross profit. A lower COGS will result in higher margins and a higher COGS will result in lower margins.
You will be wondering how we calculate the cost of goods sold. The formula is simple:
COGS = Inventory at beginning of the period + Purchases – Inventory at end of the period
COGS is highly intertwined with inventories shown on the balance sheet under current assets. This is because inventories is what a company is trying to sell to its customers so naturally inventory will be a big part of the formula.
The logic behind this formula is simple;
- Any inventories that were not sold at the end of the prior period or the beginning of the current period will be sold in the current period,
- Adding any purchases or productions made and sold during the current period,
- Less inventories left at year-end that were not sold will result in the COGS.
Inventory being a big part of the formula above, it is also important to understand how inventory balances are calculated. We mentioned earlier that COGS is quite important in determining net profit of a company since higher COGS means lower margins and lower COGS means higher margins.
Depending on how a company determines its inventory balance, there is room to play with numbers and manipulate net profit so when looking at the income statement of a company, it is also key to understand what accounting method has been used to determine inventory.
The good thing to remember is that a company can not go from one account method to another as freely as they want. When accounting standards are adopted, a company needs to have a solid valid reason to depart or change the way they account for information.
There are four accounting methods to determine the cost of inventory; FIFO, LIFO, average cost method and special identification method. COGS can be quite different depending on the method used.
FIFO: First In, First Out
The name says it all, the items that are produced first or purchased first are the first ones getting sold to customers. Generally speaking, the cost of goods usually goes up in price as time goes by due to things like inflation.
As such, selling their first items will result in a higher margin since the first items have a lower cost. Most of the time, that will cause the profit to go up year on year if using FIFO. This is a popular method adopted by various industries.
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LIFO: Last In, First Out
This method is contrary to FIFO. Instead of selling the first purchased or produced items first, LIFO means the latest purchased items or produced items are sold first to customers.
This method is a little less popular than FIFO since the latest products tend to have higher costs meaning COGS will be higher which will ultimately lead to a lower profit.
Average Cost Method
The average cost method is also a popular one where the cost is determined by using the average value of all purchased items or manufactured items for a period of time. By averaging the cost, it decreases the chances of having cost fluctuations like how FIFO or LIFO would on COGS.
Special Identification Method
The special identification method is a highly precise method where the company calculates the cost of each item sold. This means that every item being sold to a customer will have its own specific cost.
As you can imagine, this method is quite laborious so not all companies can settle with this method. The special identification method is mostly used by companies selling high-priced items like jewelleries or real estate.
Cost of Goods Sold: Final Thoughts and Recap
Cost of goods sold is any expense that is directly related to goods sold by a company as part of its operating activities. This means any purchase of raw materials, cost of labor or any other expenses that are required for the company to manufacture the goods.
COGS will exclude expenses that are administrative in nature or expenses that are borne regardless of the sale of goods such as rent and marketing costs. COGS is important in the determination of net profit as it directly impacts the margins of a company.
Inventories are an important part of COGS so knowing how inventories are calculated is also key to understanding the profitability of a company.
