What is COGS?
The cost of goods sold (COGS) is a direct cost of producing a company's goods. This amount includes the direct costs of materials and labor used to make the goods. It does not include indirect costs, such as distribution costs and sales force costs.
Cost of goods sold is also known as "Cost of sales".
- COGS includes all costs and expenses directly related to the production of goods.
- COGS does not include indirect costs such as overheads and sales & marketing.
- COGS is deducted from sales (sales) to calculate gross profit and gross profit ratio. The higher cost of goods sold leads to lower margins.
- The value of the COGS will vary depending on the accounting standards used for the calculation.
The formula of cost of goods sold
COGS = Beginning inventory + Purchases during the period -Ending inventory
Inventory sold appears in the income statement on the cost of goods sold account. Beginning inventories are inventory leftover from the previous year - that is, goods that were not sold during the previous year. Any additional product or purchase made by a manufacturing or retail company is added to the original inventory. At the end of the year, unsold items will be deducted from the beginning of the year inventory and additional purchases. The final figure obtained from the calculation is the cost of goods sold for the year.
The cost of goods sold applies only to costs directly related to the production of goods intended to be sold.
The balance sheet has an account called the current asset account. A balance sheet only reflects the financial position of the company at the end of the accounting period. This means that inventory is recognized as working assets as ending inventory. Since the opening inventory is the inventory the company had at the beginning of the accounting period, it means that the beginning inventory is also the ending inventory of the company at the end of the previous accounting period.
The cost of goods sold is an important financial statement number because it is subtracted from a company's revenue to determine its gross profit. Gross profit is a measure of profit assessing the effectiveness of a company in managing its labor and supplies in the manufacturing process.
Because the cost of goods sold is a business expense, it is recognized as a business expense in the statement of income. Knowing the cost of goods sold helps analysts, investors, and managers estimate a company's profit. If the cost of goods sold increases, the net income decreases. While this move is beneficial for income tax purposes, the business will be less profitable for its shareholders. Therefore, businesses try to keep the cost of goods sold low so net profit will be higher.
The cost of goods sold (COGS) is the cost of buying or producing the products that a company sells over some time, so the only costs that are counted on the scale are the costs directly related to its production. production costs, including labor costs, materials, and production costs. For example, an auto manufacturer's cost of goods sold will include the cost of raw materials for auto manufacturing parts plus the labor costs used to assemble the car. The cost of parking the car to the dealership and the labor costs used to sell the vehicle will be excluded.
Furthermore, costs incurred on vehicles that were not sold during the year are not included in the COGS calculation, whether direct or indirect. In other words, the cost of goods sold includes the direct cost of producing goods or services purchased by the customer during the year.
Accounting method and cost of goods sold
The cost of goods sold depends on the inventory price method adopted by a company. There are three methods a company can use when recording sold stock in a period: First In, First Out (FIFO), In-After, Out-First (LIFO), and The Average Cost Method
The earliest purchased or produced merchandise is sold first. As prices tend to increase over time, a company using the FIFO method will sell its cheapest products first, which will lead to a lower cost of goods sold than the recorded cost of goods sold. LIFO. As a result, net income using the FIFO method increases over time.
The latest goods added to stock are sold first. During periods of high prices, higher-cost goods are sold first, resulting in a higher cost of goods sold. Over time, net income tends to decrease.
- Average cost method
The average price of all stock in stock, regardless of the date of purchase, is used to determine the price of the goods sold. Calculation of the average product cost over some time has a smoothing effect so that COGS is not significantly influenced by the enormous cost of one or more acquisitions or purchases.
- Excluding from cost of goods sold deduction
Many service companies do not have any cost of goods sold. The cost of goods sold is not covered in detail in generally accepted accounting principles (GAAP), but the cost of goods sold is defined as the cost of goods sold in inventory during a given period. Not only do service companies have no goods to sell, but pure service companies have no inventory. If the cost of goods sold are not listed on the income statement, no deduction may be applied to those costs.2
Examples of pure service firms include accounting firms, law offices, real estate appraisers, business consultants, professional dancers, and more. Although all of these industries have business costs and typically spend money to provide their services, they do not list the cost of goods sold. Instead, they have what's called "cost of service", which is not included in the COGS deduction.
Cost of Revenue vs cost of goods sold
Revenue costs can include raw materials, direct labor, shipping costs, and commissions paid to sales staff. However, these items cannot be considered the cost of goods sold without the product being produced for sale.
Many service-based companies have several products for sale. For example, airlines and hotels are primarily providers of services like transportation and accommodation, but they also sell gifts, food, drinks, and other items. These items are considered commodities, and these companies certainly have an inventory of those items. Both industries can list the cost of goods sold on their income statements and report them for tax purposes.
Operating costs vs. cost of goods sold
Both operating costs and COGS are expenses that companies incur when running their businesses. However, expenses are segregated in the income statement. Unlike COGS, operating costs (OPEX) are expenses that are not directly related to the production of goods or services. Usually, sales & administration costs (selling, overhead, and overhead) are included in the operating cost as a separate line item. Selling & administration expenses are expenses that are not directly related to the product, such as overheads. Examples of operating costs include:
- To rent
- Legal fees
- Sales and marketing
- Insurance costs
Limitations of COGS
The cost of goods sold can easily be manipulated by the accountant or manager seeking to record. It can be changed by:
- Cost allocation for inventory is higher than the costs incurred
- Excessive discounts
- Returning too much to the supplier
- Changes in inventories at the end of the accounting period
- Overvaluing inventory
- Do not delete outdated inventory
When inventories are artificially inflated, the cost of goods sold will be reported lower, which will result in higher actual gross profit margins, and therefore, net income will increase.
Investors who look at a company's financial statements can uncover poor inventory accounting by checking for inventory buildup, such as inventory growing faster than revenue or Total assets are reported.
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