Cost of Goods Sold (COGS) is the total cost of producing or acquiring the goods or services that a company sells during a period. It is an important measure of a company’s profitability, efficiency, and performance, as it affects both the gross profit and the net income of the company. In this blog post, we will explain what COGS is, what it includes, how to calculate it, and why it matters for financial decision-making.

What is Included in Cost of Goods Sold (COGS)?

COGS includes all the direct and indirect costs that are related to the production or acquisition of the goods or services that are sold by the company. Direct costs are the costs that can be traced to a specific unit of output, such as raw materials, labor, and manufacturing overhead. Indirect costs are the costs that cannot be traced to a specific unit of output, but are still necessary for the production or acquisition process, such as depreciation, utilities, rent, and insurance.

However, COGS does not include all the expenses that are incurred by the company. It excludes the costs that are not directly related to the production or acquisition of the goods or services, such as selling, general, and administrative (SG&A) expenses, marketing, research and development, and interest. These costs are reported separately on the income statement as operating expenses.

How to Calculate Cost of Goods Sold (COGS)?

There are two main methods to calculate COGS: the periodic inventory system and the perpetual inventory system. The periodic inventory system calculates COGS at the end of the period, based on the beginning and ending inventory levels and the purchases made during the period. The perpetual inventory system calculates COGS continuously, based on the inventory transactions that occur during the period.

The formula for COGS under the periodic inventory system is:

COGS=Beginning Inventory+Purchases−Ending Inventory

For example, suppose a company has a beginning inventory of $10,000, purchases $5,000 worth of materials, and has an ending inventory of $8,000. The COGS is:

COGS=10,000+5,000−8,000=7,000

Why Does Cost of Goods Sold (COGS) Matter?

COGS is a crucial metric for financial analysis, as it affects the gross profit and the net income of the company. Gross profit is the difference between the sales revenue and the COGS, and it represents the amount of money that the company earns from its core business activities. Net income is the difference between the gross profit and the operating expenses, and it represents the amount of money that the company earns after paying all its expenses and taxes.

COGS also influences various financial ratios and metrics that measure the profitability, efficiency, and performance of the company, such as:

• Gross margin: This is the ratio of gross profit to sales revenue, and it indicates how much of each dollar of sales is left after paying for the COGS.
• Net margin: This is the ratio of net income to sales revenue, and it indicates how much of each dollar of sales is left after paying for all the expenses and taxes.
• Inventory turnover: This is the ratio of COGS to average inventory, and it indicates how quickly the company sells its inventory.
• Days in inventory: This is the inverse of the inventory turnover ratio, and it indicates how many days the company takes to sell its inventory.

By analyzing COGS and its impact on these ratios and metrics, managers, investors, and creditors can assess the financial health and performance of the company, and make informed decisions accordingly.

Conclusion

Cost of Goods Sold (COGS) is the total cost of producing or acquiring the goods or services that a company sells during a period. It includes both direct and indirect costs that are related to the production or acquisition process, but excludes the costs that are not directly related to the production or acquisition process. COGS is calculated using either the periodic inventory system or the perpetual inventory system, depending on how the company tracks its inventory. COGS is an important measure of a company’s profitability, efficiency, and performance, as it affects both the gross profit and the net income of the company, and influences various financial ratios and metrics that measure these aspects.