The amount of money spent producing a good or service.
Cost of Goods Sold (COGS), also sometimes referred to as “cost of sales”, is a crucial metric in accounting that reflects the direct costs associated with producing the goods a company sells during a specific period. It essentially represents the money a business spends to acquire or manufacture the products it sells to its customers.
What’s Included in COGS?
- Direct Materials: The raw materials that go into making the product. For instance, the cost of flour, sugar, and eggs for a bakery.
- Direct Labor: The wages paid to workers directly involved in producing the good. This includes assembly line workers, but not administrative staff.
- Manufacturing Overhead: Indirect costs associated with production that cannot be directly linked to a single unit. Examples include factory rent, utilities used in the production process, and depreciation of manufacturing equipment.
What’s NOT Included in COGS?
- Selling, General & Administrative Expenses (SG&A): These are indirect costs that are not directly tied to production, such as marketing, advertising, salaries for administrative staff, and rent for office space.
- Research & Development (R&D) Costs: Expenses incurred for developing new products or improving existing ones.
Why is COGS Important?
- Measure Profitability: COGS plays a vital role in determining a company’s gross profit, which is calculated by subtracting COGS from revenue. A lower COGS relative to revenue indicates higher profitability.
- Inventory Valuation: COGS is used to determine the ending inventory value on a company’s balance sheet.
- Cost Management: Analyzing COGS helps businesses identify areas where they can potentially reduce production costs and improve efficiency.
How is COGS Calculated?
There’s a primary formula used to calculate COGS, but it relies on a specific inventory costing method:
- Formula: COGS = Beginning Inventory + Purchases – Ending Inventory
The choice of inventory costing method (e.g., First-In-First-Out (FIFO), Last-In-First-Out (LIFO) or weighted average) can influence the COGS amount due to fluctuations in raw material costs over time.
