by 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.
Cost of goods sold is the accumulated total of all costs used to create a product or service, which has been sold. These costs fall into the general sub-categories of direct labor, materials, and overhead. In a service business, the cost of goods sold is considered to be the labor, payroll taxes, and benefits of those people who generate billable hours (though the term may be changed to “cost of services”). In a retail or wholesale business, the cost of goods sold is likely to be merchandise that was bought from a manufacturer. It does not include any general, selling, or administrative costs of running a business.
As revenue increases, more resources are required to produce the goods or service. COGS is often the second line item appearing on the income statement, coming right after sales revenue. COGS is deducted from revenue to find gross profit.
Accounting for Cost of Goods Sold
IFRS and US GAAP allow different policies for accounting for inventory and cost of goods sold. Very briefly, there are four main valuation methods for inventory and cost of goods sold.
- First-in-first-out (FIFO): Assumes that the items purchased or produced first are sold first. Costs of inventory per unit or item are determined at the time produces or purchased. The oldest cost (i.e., the first in) is then matched against revenue and assigned to cost of goods sold.
- Last-in-first-out (LIFO): The reverse of FIFO. Some systems permit determining the costs of goods at the time acquired or made, but assigning costs to goods sold under the assumption that the goods made or acquired last are sold first. Costs of specific goods acquired or made are added to a pool of costs for the type of goods. Under this system, the business may maintain costs under FIFO but track an offset in the form of a LIFO reserve. Such reserve (an asset or contra-asset) represents the difference in cost of inventory under the FIFO and LIFO assumptions.
- Weighted average:
- Specific identification: Under this method, particular items are identified, and costs are tracked with respect to each item. This may require considerable recordkeeping. This method cannot be used where the goods or items are indistinguishable or fungible.
Calculate the Cost of Goods Sold
The cost of goods sold is derived by adding together beginning inventory and all inventory purchases made during the reporting period, and then subtracting out the ending inventory balance. Beginning inventory is the value of the raw materials and finished goods in stock at the beginning of the reporting period. Purchases made during the reporting period include all raw materials, components, and merchandise acquired from other parties during the period. Ending inventory is the amount counted as being on hand at the end of the reporting period. The formula is:
Cost of goods sold = Beginning inventory + Purchases – Ending inventory
Items Included in Cost of Goods Sold
The items that make up costs of goods sold include:
- Cost of raw materials
- Cost of items intended for resale
- Cost of parts used to make a product
- Supplies used in either making or selling the product
- Direct labor costs
- Overhead costs, like utilities for the manufacturing site
- Shipping or freight in costs
- Indirect costs, like distribution or sales force costs
- Container costs
