Cost of goods sold

Definition

Cost of goods sold (COGS) is a key accounting metric that represents the direct costs incurred by a company in the production or purchase of the goods or services it sells during a specific period.

What is the cost of goods sold?

COGS is a key component in calculating a company’s gross profit, and is a crucial figure in the income statement as it is deducted from revenue to calculate gross profit.

Calculation of COGS:

COGS = Opening inventory + Purchases or production costs − Closing inventory

Different industries may have different methods for calculating and presenting COGS. For example, a manufacturing company’s COGS will include costs like raw materials and direct labour, while a retail company’s COGS may include the cost of purchasing goods for resale.

COGS is a deductible expense when calculating taxable income. The lower the COGS, the higher the potential taxable income and tax liability.

Cost of revenue vs. cost of goods sold

Cost of revenue and cost of goods sold (COGS) are related but distinct financial metrics. Cost of revenue includes all expenses directly tied to the production and delivery of goods and services, such as manufacturing costs, distribution, and marketing expenses. It provides a comprehensive view of the total costs related to generating revenue. In contrast, COGS specifically refers to the direct costs of producing goods sold by a company, including materials and labor. COGS does not include indirect expenses like distribution and marketing.

Operating expenses vs. cost of goods sold

Operating expenses and cost of goods sold are key financial metrics. Operating expenses includes all costs related to running a business that are not directly tied to production, such as administrative salaries, rent, utilities, and marketing. These expenses are necessary for day-to-day operations. In contrast, COGS refers specifically to the direct costs of producing goods sold by a company, including materials and labor used in production. COGS impacts gross profit, while operating expenses affect operating profit.

Example of cost of goods sold

Suppose ABC Electronics is a company that manufactures smartphones. Here’s how you might calculate COGS for a specific period, such as a quarter:

• Opening inventory (Beginning of the quarter): ABC Electronics had £500,000 worth of smartphones in inventory at the beginning of the quarter.
• Purchases or production costs (During the quarter): During the quarter, ABC Electronics incurred direct costs associated with manufacturing smartphones, including raw materials, labour, and manufacturing overhead. Let’s say these costs amounted to £1,000,000.
• Closing Inventory (End of the quarter): At the end of the quarter, ABC Electronics had £300,000 worth of smartphones still in inventory.

Now, COGS can be calculated:

COGS = £500,000 + £1,000,000 – £300,000 = £1,200,000

In this example, ABC Electronics incurred £1,200,000 in costs directly associated with producing or purchasing smartphones for sale during the quarter.