Cost of goods sold (COGS) is an important accounting term to familiarize yourself with. It is required to be presented in the financial statements under US GAAP and is widely used by analysts and investors to monitor the profitability and efficiency of a business, especially over time.
In this post, we will cover what COGS is, how to interpret it, how to calculate COGS, and how it is impacted by various cost methods.
What Is Cost Of Goods Sold (COGS)?
Cost of goods sold is a term used to categorize the cost directly related to producing a good or service. COGS is an important financial metric that is subtracted directly from gross revenue to arrive at gross profit. Because of this, COGS is considered a profitability metric as well as an accounting term.
Any expense not directly related to the production of a good or service is excluded from COGS and is instead presented in the most relevant line item on the income statement.
How To Interpret COGS
As we already mentioned, COGS is an important financial metric that analysts use in a variety of ways. Because it represents direct production costs, analysts regularly review COGS over time to identify if a business is becoming more efficient and broadening its gross profit potential.
Additionally, it is used by financial analysts to estimate various financial metrics, including net income. They do this by using COGS to calculate gross profit margin, which is then used, in conjunction with revenue expectations to arrive at expected gross profit. Finally, gross profit is reduced by estimated variable expenses to arrive at a net income estimate.
How To Calculate COGS
Modern-day accounting and Enterprise Resource Planning (ERP) systems have sophisticated means of tracking inventory and other raw materials in order to calculate COGS in real-time.
The calculation for COGS includes ending inventory across two separate periods, but in practice, inventory is only one component of COGS for certain businesses. Additionally, it might not apply to others.
The formula for calculating COGS is:
COGS= Beginning Inventory + P – Ending Inventory
Where:
P = Purchases during the period
When financial statements are presented, the amount for COGS is reflecting the inventory that was sold over the course of the period. This is especially applicable in manufacturing or retail businesses with high inventory turnover.
We can see the calculation is intuitive by rearranging it to the following:
Ending Inventory = Beginning Inventory + P – COGS
By rewriting the formula we can see that COGS is a product of ending inventory, as well as a product of gross profit. This highlights one of the many relationships between the income statement and the balance sheet.
How Cost Methods Impact COGS
Because the value for COGS is a product of inventory, it stands to reason that the costing method selected by a business may have a significant impact on it. In general, there are three primary ways that a business may calculate cost basis in inventory.
While US GAAP does have several publications that cover costing methods across various businesses and sectors, these three methods are generally associated with manufacturing and retail businesses.
First-In, First-Out (FIFO)
Under the FIFO cost method, inventory purchased at the earliest dates is assumed to be sold first. Because costs typically rise over time due to price increases, a business that chooses to present COGS in this way benefits from lower inventory costs. This, in turn, translates to higher gross profit, and presumably net income.
Last-In, Last-Out (LIFO)
LIFO is the opposite of FIFO and assumes that the most recently purchased goods are used and expensed first. Again, assuming that costs rise naturally over time this would result in a higher COGS than under the FIFO method. This in turn reduces gross profit and subsequently net income over time.
This might seem counterintuitive, but many businesses adopt this as part of a tax strategy that involves minimizing net income.
Average Cost Method
The average cost method represents the average cost of all goods in stock, without respect to when they were purchased.
By doing this, COGS is more stable and remains relatively flat over time, compared to the previous two methods. One of the benefits of doing this is that it mitigates the impact of abnormal and extreme costs.