Cost of Good Sold (COGS)

Definition of COGS

Cost of goods sold (COGS) refers to the sum of all business expenses incurred in the production of a product or service that has been sold during a period of time. The cost of the raw materials and labor used directly to make the finished product are included in this amount.

However, it does not include the indirect expenses incurred during the production process, such as shipping, marketing costs, costs of sales, and overhead costs.

COGS can also be referred to as the "cost of sales."

Why is COGS an important metric for a business?

COGS is a metric that impacts a company's financial statements as it is subtracted from revenue to calculate a company's gross profit margin.

Gross profit is a profitability measure used by companies to evaluate how efficiently they are managing their labor and supplies in the manufacturing process.

If you want to maximize profits, you need to know exactly where your money is going. By understanding COGS, you can figure out which areas of your business are costing you more than expected.

Because COGS is a direct cost incurred during the production process, it is recorded as a direct expense on the balance sheet. Companies use COGS information to make decisions on adjusting prices, making investments, increasing sales, and improving efficiency.

You can also use it to make sure you are spending money wisely. If you find that certain direct expenses are increasing while others are decreasing, you might want to consider cutting back on some of your current business expenses.

By analyzing your COGS information, you will be able to identify ways to cut unnecessary costs without hurting your bottom line.

How to use COGS to improve profitability?

In our modern economy, profit isn't just about making money. It is about creating value and growing your business. And the best way to understand whether you are doing that well is to look at your bottom line - the total amount of revenue minus the total amount of current business expenses.

If you are spending less than you bring in, you are generating profits.

The beauty of COGS is that it gives you a snapshot of your entire operation and financial health. By looking at it within your company's balance sheet, you can see where you are losing money and where you could cut production costs of your current assets. It helps you identify areas where you are overspending and even find ways to save money.

What is the relationship between accounting methods & COGS?

The value of the cost of goods sold (COGS) is determined by the type of inventory accounting method used by an organization.

The three main types of inventory accounting methods are FIFO (first in, first out), LIFO (last in, first out), and the average cost method.

FIFO

In the case of FIFO, the earliest goods purchased are removed from inventory first.

A company using the FIFO inventory management will typically be able to offer lower costs per unit sold than companies using LIFO, as prices tend to increase over time.

This means that by using the FIFO method, the net income can potentially increase.

LIFO

As new products come into the company, they replace the old ones. Since this method records the oldest items last, the net income will decline over time.

Companies using the LIFO method tend to have higher prices because they must pay more for older products.

Average Cost Method

This method calculates the average price of all the goods currently in inventory to value the goods sold.

Companies averaging the product cost over a time frame tend to smooth out the effects of acquiring an expensive asset.