COGS definition
/What is COGS?
COGS is the cost of those goods associated with product sales. It is subtracted from net revenues in order to arrive at the gross margin generated by a business. The gross margin percentage is a useful tool for analysts, who can plot it on a trendline to see if a business is maintaining its margin over time. The concept can also be applied to the provision of services, where COGS refers to the cost of the labor provided to customers.
What is Included in COGS?
The cost of goods sold includes the costs of all items that are directly or indirectly associated with the production or purchase of goods that have been sold. The main categories of costs included in COGS are direct materials, direct labor, factory overhead, and production supplies.
Only the direct materials cost is a variable cost that fluctuates with revenue levels, and so is an undisputed component of the cost of goods sold. Direct labor can be considered a fixed cost, rather than a variable cost, since a certain amount of staffing is required in the production area, irrespective of production levels.
Nonetheless, direct labor is considered a part of the cost of goods sold. Factory overhead is a largely fixed cost, and is allocated to the number of units produced in a period. Selling, general and administrative costs are not included in the cost of goods sold; instead, they are charged to expense as incurred.
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How to Calculate COGS
There are several ways to calculate COGS. At the least accurate level, it can be a simple calculation of adding purchases to beginning inventory and then subtracting ending inventory, though that approach requires an accurate ending inventory count. A more accurate method is to track each inventory item as it moves through the warehouse and production areas, and assign costs at a unit level.
COGS can also be impacted by the cost flow assumption used by a business. If a company follows the first in, first out methodology, it assigns the earliest cost incurred to the first unit sold from stock. Conversely, if it uses the last in, first out methodology, it assigns the last cost incurred to the first unit sold from stock. There are several variations on these cost flow assumptions, but the point is that the calculation methodology used can alter the cost of goods sold.
A variation on the COGS concept is to only include variable costs in it, which results in a calculated contribution margin when the variable costs are subtracted from revenues. This approach pushes fixed costs further down in the income statement.
How to Recognize COGS
COGS is recognized in the same period as the related revenue, so that revenues and related expenses are always matched against each other (known as the matching principle); the result should be recognition of the proper amount of profit or loss in an accounting period.
Presentation of COGS
The cost of goods sold is positioned midway in the income statement, immediately after all revenue line items, and prior to general, selling, and administrative expenses.
The COGS figure is frequently used as a subtraction from revenue to arrive at the gross margin ratio. This ratio is measured on a trend line basis to see if a company is maintaining its price points and manufacturing or purchasing costs in a manner that maintains its ability to generate a profit.
COGS vs. Operating Expenses
COGS includes all costs incurred to produce goods that are sold. Operating expenses are all other expenses incurred by a business, except for financing and tax expenses. Operating expenses are best described as the costs of selling, general and administrative expenses (SG&A). Operating expenses appear immediately below the COGS line item in the income statement. Examples of operating expenses are payroll, benefits, rent, office supplies, and insurance.