What is Cost of Goods Sold (COGS)?
COGS is the total of the direct costs tied to producing or buying the merchandise a business sells during an accounting period. It includes items such as raw materials, direct labor used in production, and manufacturing overhead that can be traced to the goods sold. It excludes indirect costs like sales commissions, marketing, and distribution. COGS is sometimes called cost of sales.
Why COGS matters
COGS is subtracted from revenue to compute gross profit, so it directly affects reported profitability and tax liability. A higher COGS reduces gross profit and net income; a lower COGS boosts reported profit. Because the amount depends on accounting choices (inventory method, valuation), analysts use COGS to judge production efficiency but also watch for distortions.
COGS formula (basic)
COGS = Beginning inventory + Purchases (or Production cost) − Ending inventory
Definitions of the terms
– Beginning inventory: the value of inventory carried into the period (same as prior period’s ending inventory).
– Purchases / Production cost: additional inventory bought or manufactured during the period (materials, direct labor, direct manufacturing overhead).
– Ending inventory: value of unsold inventory at period end (reported as a current asset on the balance sheet).
What is included vs excluded
Included (when directly tied to goods sold):
– Raw materials and components
– Direct manufacturing labor
– Factory overhead directly allocable to units produced (e.g., machine depreciation used in production)
Excluded:
– Sales and marketing expenses
– Distribution and shipping costs (unless the company treats them as direct cost of delivering a product)
– General & administrative salaries (unless directly traceable to production)
– Costs for inventory that was not sold in the period (they remain in ending inventory)
Quick rule of thumb: ask “Would this cost exist even if no sales occurred?” If yes, it likely is not COGS.
Common inventory accounting methods
– FIFO (First-In, First-Out): earliest-acquired goods are treated as sold first. In rising-price environments, FIFO typically yields lower COGS and higher net income.
– LIFO (Last-In, First-Out): latest-acquired goods are treated as sold first. In rising prices, LIFO usually produces higher COGS and lower net income (note: LIFO is not permitted under IFRS).
– Average cost (weighted average): uses the weighted average cost per unit for goods sold; smooths price volatility.
– Specific identification: tracks the actual cost of each individual item sold; used for unique, high-value items (cars, real estate, artwork).
Cost of revenue vs. COGS; operating expenses vs. COGS
– Cost of revenue: a broader metric some firms report that can include direct delivery or support costs required to generate revenue.
– Operating expenses (OPEX): selling, general & administrative (SG&A), R&D—these are period costs and are not part of COGS.
Who typically does not report COGS
Many pure service businesses do not report COGS because they have no physical inventory; instead they record their costs as operating expenses. Some service firms that have direct costs tied to delivering a service may use a “cost of sales” line.
Limitations and caveats
– COGS depends on inventory valuation method and can be manipulated by changing methods (within accounting rules).
– Inventory measurement errors distort COGS and balance sheet figures.
– COGS shows cost allocated to sold items, not necessarily the cash flow timing or true economic cost.
Step-by-step checklist to calculate COGS for a reporting period
1. Confirm the inventory accounting method (FIFO, LIFO, average, or specific identification).
2. Determine beginning inventory value (from prior period closing balance).
3. Add purchases or production costs made during the period (materials + direct labor + direct manufacturing overhead).
4. Count and value ending inventory at period end (using the chosen method).
5. Apply the formula: COGS = Beginning Inventory + Purchases (or Production) − Ending Inventory.
6. Ensure excluded items (SG&A, distribution, marketing) are not included in COGS.
7. Record COGS on the income statement; ending inventory goes to the balance sheet
8. Reconcile COGS with other reports and controls
– Match COGS on the income statement to supporting schedules (purchase ledger, production reports, inventory counts).
– Investigate any large or unexpected variances versus prior periods or budget.
– Ensure freight-in, purchase returns, and supplier discounts are treated consistently (usually adjust purchases).
– Confirm non-inventory expenses (selling, general & administrative — SG&A) remain excluded.
Worked numeric example (step-by-step)
Assume a merchandiser for a month:
– Beginning inventory = $50,000
– Purchases = $120,000
– Freight‑in (shipping into warehouse) = $3,000
– Purchase returns and allowances = $2,000
– Ending inventory (physical count, valued by chosen method) = $40,000
Net purchases = Purchases + Freight‑in − Purchase returns = 120,000 + 3,000 − 2,000 = 121,000
COGS = Beginning inventory + Net purchases − Ending inventory
COGS = 50,000 + 121,000 − 40,000 = 131,000
If Sales revenue = $200,000:
Gross profit = Sales − COGS = 200,000 − 131,000 = 69,000
Gross margin = Gross profit / Sales = 69,000 / 200,000 = 34.5%
Manufacturing firms — extra step: cost of goods manufactured (COGM)
Manufacturers convert raw materials into finished goods. Use:
COGM = Beginning work‑in‑process (WIP) + Total manufacturing costs − Ending WIP
Total manufacturing costs = Direct materials used + Direct labor + Manufacturing overhead (includes factory depreciation, indirect materials, indirect labor).
Then:
COGS = Beginning finished goods + COGM − Ending finished goods
Key adjustments that affect COGS but are not periodic purchases
– Depreciation of manufacturing equipment: treated as manufacturing overhead and included in COGS when the related goods are sold.
– Inventory write‑downs (obsolescence, damage): reduce inventory and increase COGS (or a separate loss line depending on accounting policy).
– Lower of cost and net realizable value (LCNRV; IFRS/US GAAP have different rules): may force a write‑down to market values.
– Shrinkage (theft, loss): discovered via periodic counts; adjust inventory and recognize COGS or a loss.
Periodic vs. perpetual inventory systems
– Periodic: inventory counts at period end determine ending inventory and COGS via the formula you already saw. Purchases are posted to a purchases account.
– Perpetual: inventory and COGS update continuously on each sale and purchase; requires robust systems and usually yields smaller reconciliation adjustments. Physical counts still necessary to detect shrinkage.
How inventory valuation method changes COGS and taxes (brief)
– FIFO (first‑in, first‑out): older costs flow to COGS first. In inflation, FIFO usually reports lower COGS and higher profit/taxes.
– LIFO (last‑in, first‑out; permitted under US GAAP but not IFRS): newer costs flow to COGS first. In inflation, LIFO typically reports higher COGS and lower taxable income.
– Weighted average smooths cost per unit across purchases.
– Specific identification assigns actual costs to specific items (used for unique, high‑value items).
Tax and performance effects depend on inflation, industry practice, and jurisdictional rules (some countries prohibit LIFO).
Quick checklist before finalizing COGS for reporting
– Confirm inventory valuation method and consistency with prior periods.
– Reconcile physical counts to perpetual records; record shrinkage.
– Verify classification of freight, returns, discounts, and purchase allowances.
– Confirm manufacturing overhead allocation bases and depreciation.
– Apply required write‑downs and document rationale/support.
– Review disclosures: inventory method, major estimates, and any LIFO disclosures if applicable.
Common red flags to investigate
– Large unexplained swings in gross margin.
– Ending inventory that appears materially higher/lower than sales trends justify.
– Frequent, large inventory write‑downs or reversals.
– Mismatch between cash paid for purchases and inventory increases (could indicate timing or misclassification issues).
Sources and further reading
– Investopedia — Cost of Goods Sold (COGS): https://www.investopedia.com/terms/c/cogs.asp
– IRS — Topic No. 703 Cost of Goods Sold: https://www.irs.gov
– U.S. Securities and Exchange Commission (SEC) — EDGAR company filings and reporting requirements: https://www.sec.gov/edgar.shtml
– Financial Accounting Standards Board (FASB) — Standards and resources (see guidance on inventory and measurement): https://www.fasb.org
– American Institute of Certified Public Accountants (AICPA) — Audit and accounting guidance, including inventory-related audit considerations: https://www.aicpa.org
– Public Company Accounting Oversight Board (PCAOB) — Auditing standards and inspection reports relevant to inventory audits: https://pcaobus.org
Educational disclaimer: This information is for educational and informational purposes only and does not constitute personalized investment, accounting, tax, or audit advice. Consult a licensed professional (accountant, auditor, or tax advisor) for guidance specific to your situation.