Cost of goods sold is found on a business’s income statement, one of the top financial reports in accounting. An income statement reports income for a certain accounting period, such as a year, quarter or month. Logically, all nonoperating costs, such as interest and capital expenditures, are excluded from COGS, too.
This means that the inventory remaining at the end of an accounting period would be the units that were most recently produced. Cost of Goods Sold (COGS) is the cost of a product to a distributor, manufacturer or retailer. Cost of goods sold is considered an expense in accounting and it can be found on a financial report called an income statement. When manufactured items are sold, their costs are removed from the Finished Goods inventory account and transferred to the Cost of Goods Sold expense account on the income statement. Cost of Goods Sold represents the amount a company paid for the manufactured items that it sold.
Where Does the Cost of Goods Sold Go on the Income Statement?
To calculate cost of goods sold, a company must understand inventory levels at different stages of the accounting period. COGS includes all direct costs incurred to create the products a company offers. Most of these are the variable costs of making the product—for example, materials and labor—while others can be fixed costs, such as factory overhead. COGS is also used to determine gross profit, which is another metric that managers, investors and lenders may use to gauge the efficiency of a company’s production processes. The gross profit helps determine the portion of revenue that can be used for operating expenses (OpEx) as well as non-operating expenses like interest expense and taxes. Cost of goods sold is an important figure for investors to consider because it has a direct impact on profits.
Cost of goods sold (COGS) is calculated by adding up the various direct costs required to generate a company’s revenues. Importantly, COGS is based only on the costs that are directly utilized in producing that revenue, such as the company’s inventory or labor costs that can be attributed to specific sales. By contrast, fixed costs such as managerial salaries, rent, and utilities are not included in COGS. Inventory is a particularly important component of COGS, and accounting rules permit several different approaches for how to include it in the calculation.
The IRS website even lists some examples of “personal service businesses” that do not calculate COGS on their income statements. In theory, COGS should include the cost of all inventory that was sold during the accounting period. In practice, however, companies often don’t know exactly which units of inventory were sold.
For oil-drilling companies, one of the most important figures you need to consider is the cost per barrel to get the oil out of the ground, refined, and sold. The average price of all the goods in stock, regardless of purchase date, is used to value the goods sold. Taking the average product cost over a time period has a smoothing effect that prevents COGS from being highly impacted by the extreme costs of one or more acquisitions or purchases. During periods of rising prices, goods with higher costs are sold first, leading to a higher COGS amount.
How to Use Cost of Goods Sold for Your Business
It requires a company to keep complete and accurate records for the GAAP calculations reported on financial statements and, separately, to support a tax return. A company’s inventory management, from both the physical and valuation perspectives, must be precise. “Operating expenses” is a catchall term that can be thought of as the opposite of COGS. It deals with the costs of running a business, but not necessarily the costs of producing a product. Operating expenses include selling, general and administrative (SG&A) expenses such as insurance, legal and accounting fees, travel, taxes and office supplies. Excluded from operating expenses are COGS items as well as nonoperating expenses, such as interest and currency exchange costs.
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- For instance, it has been noted that investor Warren Buffett knows the profitability figures for a single can of Coca-Cola and watches sugar prices regularly.
- Throughout Year 1, the retailer purchases $10 million in additional inventory and fails to sell $5 million in inventory.
- For example, airlines and hotels are primarily providers of services such as transport and lodging, respectively, yet they also sell gifts, food, beverages, and other items.
Cost of Goods Sold is matched with Sales on the first two rows of the income statement. The difference between Sales and Cost of Goods Sold is gross profit, which is the amount of markup on the manufactured goods. However, companies with inventory and cost of goods sold use a multiple-step income statement, so named because there are multiple subtractions to compute net income. In a multiple-step income statement, the accountant subtracts cost of goods sold from sales to determine gross profit. After calculating gross profit, the accountant subtracts all other expenses to arrive at net income, as My Accounting Course fully explains.
The cost of goods sold per dollar of sales will differ depending upon the type of business you own or in which you buy shares. A licensing company, advertising group, or law firm will have virtually no cost of goods sold, compared to a typical manufacturing enterprise, since they are selling a service and not a tangible product. Instead, most of their costs will show up under a different section of the income statement called “selling, general and administrative expenses” (SG&A). For example, airlines and hotels are primarily providers of services such as transport and lodging, respectively, yet they also sell gifts, food, beverages, and other items.
Uses of COGS in Other Formulas
Unlike COGS, operating expenses (OPEX) are expenditures that are not directly tied to the production of goods or services. The Cost of Goods Sold amount on the income statement is determined by considering the changes in the three inventory account balances during the period. The elements of its calculation contain important information for managers, but they are too detailed and lengthy to present directly on the income statement.
Under the matching principle of accrual accounting, each cost must be recognized in the same period as when the revenue was earned. The categorization of expenses into COGS or operating expenses (OpEx) is entirely dependent on the industry in question. It would also include the payment to your restaurant vendor for individual packets of Parmesan cheese as well as the payment to the soft drink company to refill the syrup in the soda fountains.
Steps to Calculate COGS
In some circles, the cost of goods sold is also known as cost of revenue or cost of sales. The special identification method uses the specific cost of each unit of merchandise (also called inventory or goods) to calculate the ending inventory and COGS for each period. In this method, a business knows precisely which item was sold and the exact cost.
Cost of Goods Sold is also known as “cost of sales” or its acronym “COGS.” COGS refers to the cost of goods that are either manufactured or purchased and then sold. COGS counts as a business expense and affects how much profit a company makes on its products. All of the above can become exponentially more complicated when volumes and product lines increase. For companies with many SKUs, the best approach to calculating COGS will be a robust accounting system that’s tied to inventory management. Properly calculating COGS shows a business manager the true cost of the products sold. This is critical when setting customer pricing to ensure an adequate profit margin.
Module 1: Nature of Managerial Accounting
Cost of revenue is most often used by service businesses, although some manufacturers and retailers use it as well. Similar to COGS, cost of revenue excludes any indirect costs, such as manager salaries, that are not attributed to a sale. Cost of goods sold (COGS) may be one of the most important accounting terms for business leaders to know. COGS includes all of the direct costs involved in manufacturing products. Understanding COGS, and managing its components, can mean the difference between running a business profitably and spinning on the proverbial hamster wheel to nowhere. The “cost of goods sold” refers to the direct price that goes into producing the product itself.
Calculating the COGS of a company is important because it measures the real cost of producing a product, as only the direct cost has been subtracted. The calculation of COGS is distinct in that each expense is not just added together, but rather, the beginning balance is adjusted for the cost of inventory purchased and the ending inventory. You may also want to figure out the degree to which a company is exposed to a particular input cost. For Southwest Airlines, the cost of jet fuel—and thus oil and refining—is the most important cost the company has. For example, COGS for an automaker would include the material costs for the parts that go into making the car plus the labor costs used to put the car together. The cost of sending the cars to dealerships and the cost of the labor used to sell the car would be excluded.
