Cost of goods sold (COGS) is a key concept in financial accounting and managerial finance that indicates the total cost a business incurs in producing or acquiring its inventory in order to generate revenue. COGS includes the direct costs involved in producing and delivering a product, such as the raw materials, direct labor costs, shipping and distribution, and any other costs directly associated with the manufacturing process. As a figure, COGS is often used by managers to assess profitability, measure cost efficiency, and evaluate pricing and inventory decisions.
Definition
COGS is the total amount of money a business spends in order to acquire or produce the inventory it sells. This figure represents the portion of a product’s manufacture cost which is directly associated with the production process and incurred before the item is put on the market and sold. It does not however include non-production costs such as overhead costs, shipping and storage fees, or indirect labor costs. COGS therefore is not the same as operating expenses or product overhead.
Importance
COGS is an important measure of business profitability and efficiency, which is why it is so heavily utilized by business owners and financial managers. Knowing the COGS of an item can provide managers with key insight into the cost of production, track price changes, assess production-line efficiencies or spending, and accurately measure profit margins. When creating a marketing strategy, managers may also use COGS to set prices and make decisions on how much to invest in materials and labor.
Key Features
Below are some key points to consider when calculating COGS:
* COGS should include all the costs related to the production of the goods, such as raw materials, manufacturing labor, and transportation costs.
* In cases where there are multiple inventory items, COGS should be calculated on a per-item basis in order to accurately measure the cost of producing individual products.
* The figure itself should appear on the income statement, and a company’s annual COGS should reflect the total cost of goods sold over the entire year.
Example
As an example, suppose a business produces mugs and the total cost of purchase of the raw materials is $50,000. The total cost of labor for manufacturing the mugs is $30,000, and shipping and related costs come to $10,000. In this case, the cost of goods sold would be $90,000. This figure should then be used to calculate the gross margin by subtracting it from the total revenue for the mugs.
Conclusion
COGS is an important measure of inventory costs and other direct costs associated with production. Understanding the cost of goods sold can be a powerful tool for financial managers and business decision-makers and enable them to more accurately measure profit margins and assess the profitability and cost-efficiency of operations and pricing decisions.
« Back to Glossary Index