Cost of Goods Sold (COGS)

What is Cost of Goods Sold (COGS)?

Cost of Goods Sold (COGS) measures the “direct cost” incurred in the production of any goods or services. It includes material cost, direct labor cost, and direct factory overheads, and is directly proportional to revenue. As revenue increases, more resources are required to produce the goods or service. COGS is often the second line item appearing on the income statementIncome StatementThe Income Statement (or Statement of Profit and Loss) shows performance from operations of a business. The financial statement begins with revenues and, coming right after sales revenueSales RevenueSales revenue is the starting point of the income statement. Sales or revenue is the money earned from the company providing its goods or services, income. COGS is deducted from revenue to find gross profit.Gross ProfitGross profit is the direct profit left over after deducting the cost of goods sold or cost of sales from sales revenue. It's used to calculate the gross profit margin and is the initial profit figure listed on a company's income statement. Gross profit is calculated before operating profit or net profit.

Cost of goods sold consists of all the costs associated with producing the goods or providing the services offered by the company. For goods, these costs may include the variable costs involved in manufacturing products, such as raw materials and labor. They may also include fixed costs, such as factory overhead, storage costs, and depending on the relevant accounting policies, sometimes depreciation expense.

COGS does not include general selling expenses, such as management salaries and advertising expense. These costs will fall below the gross profit line under the selling, general and administrative (SG&A) expenseSG&ASG&A includes all non-production expenses incurred by a company in any given period. This includes expenses such as rent, advertising, marketing, accounting, litigation, travel, meals, management salaries, bonuses, and more. On occasion, it may also include depreciation expense section.

Purpose of Cost of Goods Sold

The basic purpose of finding COGS is to calculate the “true cost” of merchandise sold in the period. It doesn’t reflect the cost of goods that are purchased in the period and not being sold or just kept in inventory. It helps management and investors monitor the performance of the business.

Accounting for Cost of Goods Sold

IFRSIFRS StandardsIFRS standards are International Financial Reporting Standards (IFRS) that consist of a set of accounting rules that determine how transactions and other accounting events are required to be reported in financial statements. They are designed to maintain credibility and transparency in the financial world and US GAAP allow different policies for accounting for the cost of goods sold. Very briefly, there are four main types of cost of goods sold classifications.

1. First-in-first-out (FIFO)First-In First-Out (FIFO)The First-In First-Out (FIFO) method of inventory valuation accounting is based on the assumption that the sale or usage of goods follows the same order in which they are bought. In other words, under the FIFO method, the earliest purchased or produced goods are removed and expensed first. The most recent costs remain
2. Last-in-first-out (LIFO)Last-In First-Out (LIFO)The Last-in First-out (LIFO) method of inventory valuation is based on the assumption that assets produced or acquired last are the first to be expensed. In other words, under the FIFO method, the latest purchased or produced goods are removed and expensed first. Therefore, the old inventory costs remain on the
3. Weighted average
4. Specific identification

The first two are self-explanatory. Under FIFO, COGS consists of earlier costs, whereas under LIFO, COGS consists of later costs. For example, assume that a company purchased materials to produce four units of their goods. The first three units cost $5 to produce. However, due to rising material prices, the last unit costs $10 to produce. In the subsequent period, the company sells three units. Under FIFO, COGS would consist of the first three units produced, totaling $5 x 3 = $15. Under LIFO, COGS would consist of the last three units produced, totaling $10 x 1 + $5 x 2 = $20.

Under weighted average, the total cost of goods available for sale is divided by units available for sale to find the unit cost of goods available for sale. This is multiplied by the actual number of goods sold to find the cost of goods sold. In the above example, the weighted average per unit is $25 / 4 = $6.25. Thus, for the three units sold, COGS is equal to $18.75.

Specific identification is special in that this is only used by organizations with specifically identifiable inventory. Costs can be directly attributed and are specifically assigned to the specific unit sold. This type of COGS accounting may apply to car manufacturers, real estate developers, and others.

Depending on the COGS classification used, ending inventory costs will obviously differ.

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More resources

Thank you for reading this guide to accounting for the cost of goods sold. CFI is the official provider of the Financial Modeling & Valuation Analyst (FMVA)™ certificationFMVA™ CertificationThe Financial Modeling & Valueation Analyst (FMVA)™ accreditation is a global standard for financial analysts that covers finance, accounting, financial modeling, valuation, budgeting, forecasting, presentations, and strategy. . To prepare for the FMVA curriculum, these additional resources will be helpful:

• Fixed and Variable CostsFixed and Variable CostsFixed and variable costs are important in management accounting and financial analysis. Fixed costs do not change with increases/decreases in units of production volume, while variable costs are solely dependent on the volume of units of production. This guide teaches an analyst the fixed vs variable cost methods
• Cost of Good ManufacturedCost of Goods Manufactured (COGM)Cost of Goods Manufactured (COGM) is a schedule showing the total production costs during a specific period of time. See COGM formula & examples in this guide. COGM is the total costs incurred to manufacture products and transfer them into finished goods inventory for actual retail sale
• Job Order Costing GuideJob Order Costing GuideJob Order Costing is used to allocate costs based on a specific job order. This guide will provide the job order costing formula and how to calculate it. As an example, law firms or accounting firms would use job order costing because every client is different and unique. Process-costing, on the other hand can be used
• Activity-based Costing GuideActivity-Based CostingActivity-based costing is a more specific way of allocating overhead costs based on “activities” that actually contribute to overhead costs. An activity is an event, task, or unit of work with a specific purpose, whether it be designing products, setting up machines, operating machines, or distributing products. Therefore, activity-based costing considers all these potential activities