What is Cost of Goods Sold? Why is It Important?

What is Cost of Goods Sold? Why is It Important?

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Businesses that sell products naturally want to know how efficiently they are operating. One important metric in this regard is gross profit during a period, which is the revenue generated by sales minus the cost of goods sold (COGS). COGS is a measure of the cost incurred by a business to acquire or produce the goods it sells. We break down what COGS is, how to calculate it and what it means.

Cost of Goods Sold Explained

The value of COGS represents the costs a merchandiser incurs for the acquisition of the goods it sells, or the costs for a manufacturer to produce the products it sells during the period. The costs encompassed by COGS include those for direct labor, materials, parts and manufacturing overhead. They do not include distribution, selling or indirect overhead costs (i.e., overhead costs such as accounting and office supplies that are not directly tied to specific inventory items).

In practice, COGS is calculated by adding the costs of inventory purchased or produced during a period to the beginning inventory, then subtracting the cost of the ending inventory:

Cost of Goods Sold = Beginning Inventory + Additional Inventory – Ending Inventory

These are how the COGS terms are defined:

  • Beginning inventory: How much it costs to produce or purchase the inventory on hand at the beginning of the period. It’s equal to the ending inventory for the previous period, as reflected on the balance sheet for that period. Costs include how much the business spent to accumulate the inventory, consisting of the labor directly used to produce or purchase it, as well as product-related materials, supplies, parts and direct overhead (for example, rent, electricity, etc. directly used to produce the inventory).
  • Additional inventory: The cost to purchase or produce additional inventory during the period.
  • Ending inventory: The cost of the inventory on hand at the end of the period, as reflected on the period-end balance sheet.

How to Calculate Cost of Goods Sold

Before you can calculate COGS, you need to define a costing method to put a cost on ending inventory. There are three choices; we explain FIFO vs LIFO accounting here:

  • First in, first out (FIFO): The first item added to inventory is the first item sold. Since prices increase over time, this minimizes COGS and maximizes profits and taxes.
  • Last in, first out (LIFO): The last (and usually the most expensive) unit added to inventory is the first item sold, which maximizes COGS and minimizes profits and taxes.
  • Average cost: Costs are averaged regardless of purchase or production date. This tends to smooth out COGS, profits and taxes.

Costs that go into inventory value include:

  • Purchases: The total amount of purchases you made for the products you put into inventory. Typically used by merchandisers to represent the wholesale costs of the products they sell.
  • Materials: The costs of materials and supplies needed to make your product. This is typically used by manufacturers to account for the costs for raw materials and assemblies.
  • Labor: The total costs for paying employees and contractors who directly work on producing your inventory.
  • Other direct costs: The costs of overhead items like electricity, water and rent tied directly to places where inventory is manufactured or assembled.

The following example illustrates the COGS calculation:

Galactic Sprockets Co. manufactures complex sprocket assemblies, using simple sprocket parts it purchases. The balance sheet dated Dec. 31, 2016 puts ending inventory cost at $12.5 million, which is also the beginning inventory cost for 2017. During the year, Galactic purchases $25 million of raw parts and related supplies, and it applies another $15 million in labor and other direct costs to create additional inventory valued at $40 million using the average costing method. The ending inventory on Dec. 31, 2017, is physically counted and valued at $14 million. Using these facts to calculate COGS for 2017:

  • COGS = Beginning Inventory + Additional Inventory – Ending Inventory
  • COGS = $12.5 million + $40 million – $14 million = $38.5 million

Assume that Galactic earned net sales revenues of $61 million in 2017:

  • Gross Profit = Net Sales Revenue – COGS
  • Gross Profit = $61 million – $38.5 million = $22.5 million

Net sales revenue is equal to total sales minus adjustments for returns, loss allowances and post-sale rebates. Had Galactic used FIFO costing, COGS would have been smaller and gross profit would have been larger. Conversely, using LIFO costing would give Galactic a larger COGS and a smaller gross profit.

How to Interpret Cost of Goods Sold

COGS should be interpreted as an indication of operational efficiency. A well-run business minimizes its COGS by protecting against unnecessary costs like damage, spoilage, theft, overstocking (keeping too much inventory on hand generates higher storage costs) and stock outs (missing inventory causes lost revenue and/or expensive expedited shipping costs). If COGS shows a sudden spike or trend rising faster than sales, management will want to figure out why and find ways to correct any related problems.

For example, if you have a substantial inventory theft problem, your ending inventory will be lower than you anticipate. Since ending inventory reduces COGS, a lower ending inventory will result in a higher COGS and lower profits. This should motivate management to solve the theft problem.

Another use of COGS is to compare the costs of different products sold by a business. It could be that a particular product with a higher COGS might be less profitable than other products sold and perhaps should be discontinued or redesigned to reduce costs.

Finally, if the price of a product is determined by market supply, and your company’s COGS is too high to sell the product at a profit, it invites consideration as to whether to exit the business, or perhaps to invest in ways to reduce your COGS.

What Ratios or Financial Metrics is COGS Used In?

We have already explored the relationship between gross profit and COGS. Closely related is gross margin, which is:

Gross margin = (Sales Revenue – COGS) / Sales Revenue

The higher the gross margin, the more the business retains from each dollar of revenue. A decline is gross margin is a warning that some issue needs to be addressed.

Two ratios related gross margin are:

  • COGS ratio = COGS / Net Sales
  • Gross markup = Gross Profit / COGS Ratio

A business strives for a low COGS ratio, meaning costs of producing a product are relatively low compared to the sales generated. Conversely, a company will prefer a high gross markup, meaning it can sell product at price well above the cost of producing it.

Another ratio that uses COGS is inventory turnover, which measures how frequently a business’ inventory is sold and replaced over a period of time:

Inventory turnover = COGS / Average Inventory = COGS / ((Starting Inventory + Ending Inventory) / 2)

A high inventory turnover means sales are strong (or highly discounted), while low inventory turnover indicates weak sales and excessive inventory. If you divide 365 days by the inventory turnover, you get the number of days to completely sell your inventory. For example, if you turn over your inventory 10 times a year, then it takes 36.5 days on average to sell out your inventory.

Lenders look at a business’ COGS in relationship to previous COGS amounts to determine if a trend exists. A COGS that is rising faster than sales is a warning sign that costs are not under control. Lenders also compare a company’s COGS with those of its closest competitors to see whether it is seriously out of whack. If the COGS is too high, it could mean the company is inefficient and thus less creditworthy. If it is significantly lower than every other competitor’s COGS, then the business is either very efficient or is cooking the books. In either case, further research is indicated.

Madison is a former Research Analyst at ValuePenguin who focused on student loans and personal loans. She graduated from the University of Rochester with a B.A. in Financial Economics with a double minor in Business and Psychology.