Costs of Goods Sold (COGS)

Costs of goods sold (COGS) represents the direct costs attributable to the production of the goods sold by a company during a specific period. It is a critical component of a business's financial accounting and appears on the income statement directly below revenue. By subtracting costs of goods sold from revenue, businesses determine their gross profit, an essential indicator of a company's operational efficiency. These costs are considered an expense in the period the corresponding goods are sold.

History and Origin

The concept of meticulously tracking and allocating production costs, which forms the basis of costs of goods sold, has roots in the Industrial Revolution. As manufacturing processes became more complex and enterprises grew in scale during the late 18th and early 19th centuries, the need for systematic cost determination became paramount. Early iterations of cost accounting emerged to provide businesses with better control over material and labor expenses, moving beyond simple inventory counts to more sophisticated methods for managing the true cost of production. This historical development underscores the fundamental importance of understanding the internal economics of a business.⁴

Key Takeaways

• Costs of goods sold (COGS) includes direct costs like raw materials, direct labor, and manufacturing overhead directly tied to producing goods for sale.
• It is a key determinant of a company's gross profit, providing insight into the efficiency of its production and pricing strategies.
• COGS is reported on a company's income statement and directly impacts its overall profitability.
• Inventory valuation methods, such as First-In, First-Out (FIFO) or Weighted-Average Cost, significantly influence the calculated value of COGS.
• Accurate COGS calculation is vital for both financial reporting under accounting standards and for tax compliance.

Formula and Calculation

The calculation of costs of goods sold typically follows a straightforward formula:

Where:

• Beginning Inventory: The value of unsold goods from the previous accounting period.
• Purchases (or Cost of Goods Manufactured): The cost of new inventory acquired or produced during the current accounting period. This includes direct materials, direct labor, and manufacturing overhead.
• Ending Inventory: The value of unsold goods remaining at the end of the current accounting period.

For manufacturing companies, "Purchases" is replaced by "Cost of Goods Manufactured," which encompasses all direct and indirect costs incurred in the production of finished goods during the period.

Interpreting the Costs of Goods Sold

Understanding costs of goods sold is crucial for assessing a company's operational profitability. A company with a high volume of sales but also high costs of goods sold may have thin gross margins, indicating inefficiencies in production, high supplier costs, or insufficient pricing power. Conversely, a low COGS relative to revenue suggests efficient production or strong pricing strategies.

Analysts frequently use COGS in conjunction with revenue to calculate the gross profit margin, a percentage that reveals how much profit a company makes from each dollar of sales after accounting for direct production costs. This metric is a vital input for financial analysis and benchmarking against industry peers.

Hypothetical Example

Consider "Gadget Co.," a company that manufactures smart home devices.
At the beginning of the year, Gadget Co. had an inventory valued at $50,000 (Beginning Inventory).
During the year, the company spent $300,000 on raw materials, direct labor, and manufacturing overhead to produce new devices (Purchases/Cost of Goods Manufactured).
By the end of the year, after selling many devices, Gadget Co. conducted a physical count and determined its remaining inventory was worth $70,000 (Ending Inventory).

Using the formula:
Costs of Goods Sold = $50,000 (Beginning Inventory) + $300,000 (Purchases) - $70,000 (Ending Inventory)
Costs of Goods Sold = $280,000

If Gadget Co.'s total revenue from device sales for the year was $500,000, its gross profit would be $500,000 - $280,000 = $220,000.

Practical Applications

Costs of goods sold plays a fundamental role in various aspects of business and financial analysis:

• Pricing Strategy: By understanding the direct costs of production, companies can set appropriate selling prices to ensure desired profit margins.
• Profitability Analysis: Investors and analysts use COGS to evaluate a company's ability to control its core production costs and generate profit from sales.
• Inventory Management: Efficient inventory management directly impacts COGS. Practices such as Just-In-Time (JIT) aim to minimize inventory holding costs, which can reduce the overall COGS burden. Effective supply chain management can lead to favorable pricing on raw materials and components, also reducing COGS.
• Taxation: COGS is a deductible expense for businesses, directly reducing taxable income. The Internal Revenue Service (IRS) provides detailed guidelines on what costs can be included in COGS for tax purposes.
• Strategic Decision-Making: Changes in COGS can signal underlying shifts in a company's cost structure, market conditions, or supplier relationships. For example, Molson Coors Beverage Company reported in Q2 2025 that increased variable costs per hectoliter, driven by factors like "cost inflation related to materials and manufacturing expenses," negatively impacted its profitability despite higher net pricing.³ Understanding these impacts allows management to make informed decisions about operations, sourcing, and pricing. Conversely, reducing fixed costs associated with production, such as rent for a manufacturing facility, also impacts the COGS calculation.

Limitations and Criticisms

While costs of goods sold is a crucial metric, it has certain limitations and can be subject to manipulation or misinterpretation, depending on the chosen accounting methods.

One primary criticism relates to inventory valuation methods, such as FIFO (First-In, First-Out), LIFO (Last-In, First-Out), and Weighted-Average Cost. Each method can yield a different COGS figure for the same period, especially during times of fluctuating material costs. For instance, LIFO (not permitted under International Financial Reporting Standards but allowed under U.S. GAAP) can result in a higher COGS during inflationary periods, leading to lower reported profits and, consequently, lower tax liabilities. This variability makes direct comparisons between companies using different methods challenging. The Financial Accounting Standards Board (FASB) regularly updates guidance, such as Accounting Standards Update (ASU) No. 2015-11, to simplify inventory measurement, which in turn impacts COGS calculations.²

Additionally, COGS only includes direct costs. Indirect costs like administrative expenses, sales and marketing, and even depreciation on administrative assets are excluded. This means COGS alone does not provide a complete picture of a company's total expenses or true financial health. Companies operating under accrual accounting principles must carefully allocate costs to inventory, which later become COGS when the asset is sold. Inaccurate cost allocation can distort COGS and, subsequently, a company's reported profitability. For publicly traded companies, the Securities and Exchange Commission (SEC) provides extensive guidance on financial reporting to ensure transparency, including proper COGS reporting.¹

Costs of Goods Sold vs. Operating Expenses

Costs of goods sold (COGS) and operating expenses are both essential categories of expenses found on a company's income statement, but they represent distinct types of costs. The key difference lies in their directness to the production or acquisition of the goods sold.

COGS includes only the direct costs associated with manufacturing or purchasing the products that a company sells. This encompasses the cost of raw materials, the direct labor involved in production, and manufacturing overhead directly tied to the factory floor (e.g., utility costs for the production facility). These costs are directly variable with the volume of goods produced.

In contrast, operating expenses (often referred to as Selling, General, and Administrative, or SG&A) are the indirect costs incurred in running a business that are not directly related to the production of goods. These include expenses such as salaries of administrative staff, marketing and advertising costs, rent for office space, utilities for the sales department, and research and development expenses. Operating expenses are typically more fixed or period-based compared to the variable nature of most COGS components. Both are deducted from revenue to arrive at different levels of profit, with COGS leading to gross profit, and operating expenses (along with COGS) leading to operating income.

FAQs

What is included in Costs of Goods Sold?

Costs of goods sold includes the direct costs involved in producing or acquiring the goods a company sells. This typically encompasses raw materials, direct labor (wages of workers directly involved in manufacturing), and manufacturing overhead (factory rent, utilities, and depreciation of production equipment).

Why is Costs of Goods Sold important?

COGS is crucial because it directly impacts a company's gross profit, which indicates how efficiently the business produces and sells its products. A lower COGS relative to sales generally means higher profitability. It's also a significant deduction for tax purposes.

Do service-based businesses have Costs of Goods Sold?

Generally, pure service-based businesses, such as law firms or consulting agencies, do not have costs of goods sold because they do not sell physical products. However, if a service business also sells products (e.g., a salon selling hair care products), it would calculate COGS for those product sales.

How does inventory valuation affect Costs of Goods Sold?

The method a company uses to value its inventory (e.g., FIFO, LIFO, Weighted-Average) directly impacts the calculated costs of goods sold. Different methods can lead to varying COGS figures, which in turn affects reported gross profit and net income on the income statement and the value of inventory reported on the balance sheet.

Is Costs of Goods Sold an asset or an expense?

Costs of goods sold is an expense that appears on the income statement. While the costs initially reside as an asset (inventory) on the balance sheet, they are expensed as COGS once the corresponding goods are sold.