What is Cost of Goods Sold (COGS)?
How Does Cost of Goods Sold (COGS) Work?
For goods, COGS is primarily composed of the cost of the raw materials that physically constitute the item. But cost of goods sold does not include indirect expenses, such as utilities, office supplies, or items not associated with the production of a specific good or service.
Let's assume Company XYZ incurs the following costs to produce one pair of eyeglasses:
Plastic frame $10
By adding these direct expenses, we can calculate that it costs Company XYZ $17 to make one pair of eyeglasses. If Company XYZ's raw materials prices never changed, it might be practical for Company XYZ to calculate total cost of goods sold by multiplying $17 by the number of eyeglasses sold in a period. However, raw materials prices frequently do change, and when Company XYZ sells a pair of eyeglasses, it must determine exactly which materials it was selling.
For example, let's assume Company XYZ purchased 100 plastic frames in January for $10 each, 50 frames in February for $9 each, and 200 frames in March for $11 each. When Company XYZ sells a pair of eyeglasses in April, which cost does Company XYZ use: $10, $9, or $11? Company XYZ's choice of inventory valuation methods (which generally include the last in, first out (LIFO), first in, first out (FIFO), and weighted-average methods) dramatically affects COGS (and by extension, profit) it lists on the income statement.
Company XYZ's choice of which inventory units to sell first affects the value of its remaining inventory and its total cost of goods sold for the period. If Company XYZ began the month with $100 of inventory, purchased $500 of inventory during the month, and ended the month with $200 of inventory, we can calculate that Company XYZ's total cost of goods sold equaled:
$100 + $500 - $200 = $400
Why Does Cost of Goods Sold (COGS) Matter?
Cost of goods sold is the primary component in calculating gross profit, and it affects nearly every other profit measure. Calculating COGS is the primary reason most companies take inventory every month.
It is important to understand that different inventory methods typically generate different costs of goods sold for identical companies, and it is therefore necessary to study a company's inventory valuation disclosure when evaluating cost of goods sold. When comparing companies, it is also important to note that some industries tend to have higher COGS than others. This is why comparisons are generally most meaningful among companies using the same inventory method within the same industry, and the definition of "high" or "low" cost should be made within this context.