Cost of Goods Sold (COGS), also known as cost of sales or direct production cost, is the amount of money a business spends in the direct manufacturing of a good. It includes expenses such as labor and materials, with other areas, such as marketing and shipping, usually considered as indirect charges. Typically represented through a simple addition and subtraction formula, it connects closely to profit, budgeting and supply and demand, as well as inventory valuation. It can be extremely complex to deal with, simply because most businesses make and sell more than one thing, with every product having its own price to manufacture.
Basic Formula
When companies look at their merchandise inventory, they look at how many goods they started with and then add in how many they acquired over time, which gives them the total amount of merchandise they can sell. They often refer to this as the cost of goods available for sale. At the end of a given period, they usually assume that people bought whatever isn’t in the inventory anymore, although this system has flaws and doesn’t account for problems such as theft or worker misplacement of goods. Based on this strategy, businesses generally calculate COGS based on the following formula:
Relationship to Profit
A business can determine the gross profit earned on a particular good by subtracting the COGS from the sales revenue. Similarly, it can use the cost of sales to calculate net profit, subtracting it along with other expenses such as taxes. Both of these figures are extremely important, because they allow a company to analyze whether making a specific item is financially worth it.
As an example, a manufacturer takes in $10,000 USD in revenue in the month of November. Direct expenses or COGS totaled $4,000, while indirect expenses added to $1,000. Gross profit is $10,000 - $4,000, or $6,000. Net profit is $10,000 - $4,000 - $1,000, or $5,000.
If both profits and costs go down, it’s not necessarily a loss of a business, but it still can be a reason for concern when the drop in revenue is much higher than the decrease in costs. In the same way, a rise in both COGS and revenue isn’t a guarantee of a giant profit. Most executives focus on finding ways to maintain — or ideally, to reduce — the price of production while increasing revenue, but doing this without eliminating jobs or sacrificing the quality of the goods is tricky.
Connection to Budget
By looking at the COGS for previous periods, companies often are able to make some assumptions about how expensive it might be to continue making a good. They can use these calculations to determine how many units it’s possible to make within the current budget. This links closely to production planning, which also connects to other basic operations such as employee scheduling. At the end of a period, accountants can compare what the business thought it was going to spend based on what really happened, and they usually try to analyze what caused any disparities to make sure they have enough cash on hand for next time.
Variability and Supply and Demand
Outside forces, such as the cost of a material, can change over time, sometimes in as little as a day. When the price of oil spikes, for instance, the cost of gas usually soars, and as a result, people often don’t buy as much, thereby decreasing how much of a profit the gasoline seller makes. Such a price increase frequently cuts the COGS, because the business usually doesn’t sell as many goods. Supply and demand, therefore, directly connects to cost of sales.
Inventory Valuation
When the price of production involves any variable cost, which is typically the case, the COGS depends on the inventory valuation method the business uses. With the first-in, first-out (FIFO) method, older inventory is always sold first — grocery stores almost always use this strategy. Last-in, first-out (LIFO) is exactly the opposite, which can be better when executives need to handle extreme inflation and control taxable income, or when they want to get a good match between what’s sold and how much they’re spending on production. The average cost method takes the number of goods in inventory at the start of a given period and then uses how many were sold to get an average cost for each item. With this average, managers or other leaders can figure out the value of the inventory available at the end of the period, as well as the COGS.
Production Despite Loss Risk
In most cases, companies produce something only when the market value for that item is greater than the expense of making it, because otherwise, the odds of making a profit are very low. There are some rare instances when businesses willingly take this risk, however. Executives might offer an expensive-to-produce item as a thank you for buying a membership, for example. They usually know that making these “gifts” or incentive products creates some loss, but they feel that the potential for future sales justifies the spending.
Complexity
Even when executives are able to keep track of all production cost variables for real-time monitoring, handling the COGS can be extremely complex, because most companies make more than one good. They have to calculate expenses for each one, which can be time consuming, and which generally requires massive amounts of data. It’s not unusual for companies to hire accountants specializing in this area for this reason, especially when they want to have formal reports and presentations available for shareholders and other investors.
