Cost of Goods Sold (COGS)

Cost of Goods Sold (COGS)

Cost of Goods Sold (COGS) is the direct cost of producing or acquiring the goods a company sells during a reporting period. It excludes indirect expenses such as distribution, marketing, and most overhead. COGS is deducted from revenue to calculate gross profit and gross margin.

Key takeaways

• COGS includes direct materials, direct labor, and manufacturing overhead tied to goods sold.
• It excludes indirect operating costs like rent, utilities, and general administrative salaries.
• Inventory valuation method (FIFO, LIFO, average cost, or specific identification) affects COGS and reported profit.
• Service-only businesses typically report no COGS; they record operating expenses or cost of services instead.

Why COGS matters

COGS determines gross profit (Revenue − COGS). A higher COGS lowers gross margin and net income, so companies monitor COGS to assess production efficiency, pricing, and profitability. Investors and analysts use COGS trends to evaluate cost control and inventory management.

What is included in COGS

Typical components:
* Direct materials used to make products
* Direct labor involved in production
* Manufacturing overhead directly tied to production (e.g., factory supplies, production-related utilities)
* Freight-in or shipping costs to acquire inventory (but generally not the cost to ship finished goods to customers)

Costs not included:
* Selling, general, and administrative expenses (SG&A)
* Most salaries and corporate overhead
* Distribution and sales commissions (unless directly attributable to production)

Deciding whether a cost belongs in COGS hinges on whether the cost would exist only if production occurred and sales were made.

Basic formula

COGS = Beginning Inventory + Purchases (or Production Costs) − Ending Inventory

• Beginning inventory is the unsold inventory carried from the prior period.
• Purchases or production costs are added during the period.
• Ending inventory is subtracted because it was not sold during the period.

Inventory on the balance sheet represents ending inventory for that reporting period.

Inventory valuation methods

The inventory method chosen affects which costs are recognized as COGS:

• FIFO (First-In, First-Out): Assumes oldest inventory is sold first. In rising-price environments, FIFO usually yields lower COGS and higher reported profit.
• LIFO (Last-In, First-Out): Assumes newest inventory is sold first. In rising prices, LIFO generally produces higher COGS and lower reported profit.
• Average cost: Uses the weighted-average cost of inventory; smooths out price volatility.
• Specific identification: Tracks the actual cost of each distinct item; used for unique or high-value items (e.g., cars, jewelry).

Companies that typically don’t report COGS

Pure service businesses that don’t hold inventory (e.g., law firms, accounting firms, consultants) generally do not report COGS. They record their costs as operating expenses or cost of services. Businesses that offer both services and goods (airlines selling in-flight items, hotels selling amenities) will report COGS for the goods they sell.

Cost of revenue, cost of sales, and operating expenses

• Cost of Revenue / Cost of Sales: Sometimes used more broadly than COGS to include other direct costs of generating revenue (for example, certain customer-delivery or contract service costs).
• Operating Expenses (OPEX): Expenses not directly tied to production (rent, utilities, marketing, admin). These are presented separately from COGS on the income statement.

Limitations and potential manipulation

COGS can be manipulated through inventory accounting choices or misstatements, such as:
* Overstating ending inventory
* Misallocating overhead to inventory
* Failing to write off obsolete inventory

Manipulation can inflate gross profit and net income. Analysts watch for abnormal inventory growth relative to sales or assets to spot issues.

Practical calculation steps

1. Determine beginning inventory (from the prior period’s ending inventory).
2. Add purchases or manufacturing costs during the period.
3. Subtract ending inventory (physical count or perpetual system value).
4. Apply the chosen inventory valuation method consistently.

Remember: only include costs that can be directly tied to producing the goods sold.

How inventory valuation affects reported profit

Because different valuation methods assign different cost layers to sold goods, the same physical flow of goods can produce different COGS and profits. In inflationary periods, FIFO tends to report higher profits than LIFO.

Bottom line

COGS is a fundamental measure of the direct cost of producing goods sold. Accurate COGS calculation and consistent inventory valuation are essential for reliable financial reporting, tax compliance, and assessing operational efficiency. Reducing COGS (through supplier negotiation or production improvements) increases gross profit and supports stronger overall profitability.