What is Cost of Goods Sold (COGS)?
Cost of Goods Sold (COGS), otherwise known as the “cost of sales”, refer to the direct costs incurred by a company while selling its goods/services.
How to Calculate Cost of Goods Sold (Step-by-Step)
The cost of goods sold (COGS) is the accounting term used to describe the direct expenses incurred to produce revenue.
On the income statement, the cost of goods sold (COGS) line item is the first expense following revenue (i.e. the “top line”).
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The categorization of expenses into COGS or operating expenses (OpEx) is entirely dependent on the industry in question.
For instance, the “Cost of Direct Labor” is recognized as COGS for service-oriented industries where the production of the company’s goods sold is directly related to labor.
But not all labor costs are recognized as COGS, which is why each company’s breakdown of their expenses and the process of revenue creation must be assessed.
As another industry-specific example, COGS for SaaS companies could include hosting fees and third-party APIs integrated directly into the selling process.
Under the matching principle of accrual accounting, each cost must be recognized in the same period as when the revenue was earned.
For instance, just the costs associated with the inventory sold in the current period can be recognized on the income statement, which is where the LIFO vs FIFO inventory accounting methods can be a source of debate.
Cost of Goods Sold Definition (COGS)
COGS Definition (Source: IRS.gov)
Cost of Goods Sold Formula (COGS)
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.
- Beginning Inventory → The amount of inventory rolled over (i.e. leftover) from the prior period
- Purchases in Current Period → The cost of purchases made during the current period
- Ending Inventory → The inventory NOT sold during the current period
Operating Costs: Cost of Goods Sold vs. Operating Expenses
Conversely, COGS excludes operating expenses – i.e. indirect costs – such as overhead costs, utilities, rent, and marketing expenses.
While a broad generalization, COGS tend to consist of variable costs, as the value is dependent on the production volume.
In contrast, OpEx tends to consist of fixed costs, which means the value remains relatively constant regardless of the level of production output.
For example, a company’s rental expense for a facility remains fixed based on a signed rental agreement.
The way you broke out the formulas in this article is extremely helpful – thank you! I’d also recommend this article for those trying to understand the business impact of COGS on other metrics and the importance of accuracy of the COGS numbers: https://lucrumconsulting.com/understanding-cost-of-goods-sold-cogs/