What is Cost of Goods Sold?

Cost of goods sold or COGS represents costs that are directly related to the manufacturing and distribution of products. The primary costs that must be included in the calculation of cost of goods sold include raw materials, packaging, overhead, direct labor (and indirect labor if it is production related, i.e. supervisory labor), depreciation of manufacturing and distribution facilities, as well as shipping and handling. In other words, it is the total direct cost of producing or creating a product or a service.

The calculation includes manufacturing overheads (as long as they are production-related) and associated expenses, such as direct labor costs, tools and factory supplies.

Key Learning Points

  • Cost of goods sold (COGS) are expenses related directly to the manufacturing and distribution of a product
  • Gross profit is the profit of a manufacturing or a direct service and is calculated as sales less COGS
  • COGS are expenses and are therefore reported in a company’s income statement along with all other revenues and expenses for the period
  • COGS represents inventory sold and is directly linked to the inventory balance a company reports in its financial statements

Key Ratios

  • Gross Margin – Shows the profits of production which is driven by both price advantages and cost advantages. It measures how effectively a company turns its revenue into profit. To calculate the ratio, divide gross profit by the revenue. This is then expressed as a percentage.
  • Cost of Goods Sold to Sales – Measures the direct costs incurred for the production of goods during a specific period, compared to the revenue earned as a result of those costs. The formula is cost of goods sold divided by revenue.

Cost of Goods Sold in the Financial Statements

Accounting policy that stipulates the expenses used to calculate the line item.

The Hershey Company – Extract from footnote 1

Inventory and COGS

Inventory and COGS are linked in the income statement as the line item COGS represents inventory sold. The inventory which has been sold to customers is removed from the balance sheet and transferred to COGS in the income statement. The relationship between these items can be summarized in an inventory BASE analysis as follows:

The example above shows us how we obtain the inventory balance. We start with the opening balance, add purchases and subtract the inventory sold to customers (COGS).

Periodic vs Perpetual Inventory Systems

Companies can use periodic or perpetual systems to keep track of their inventory. The periodic inventory system is usually found in small businesses that have low sales volumes such as a car dealership, whereas large businesses, such as supermarket retailers, use perpetual inventory systems.

With a periodic inventory system, companies count their inventory occasionally and update it at the end of the period in question. In a perpetual inventory system, companies continuously count their inventory and record purchases and returns immediately.