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What is cost of goods sold?
The amount a company spends on making goods or acquiring goods for resale is referred to as cost of goods sold (COGS) or cost of sales. These costs include materials costs, labor expenditures, and purchase costs. COGS is a key measure for determining a company’s gross profit margin.
A business calculates gross profit by subtracting COGS from revenue, and calculates net profit by subtracting COGS and all other expenditures from sales revenue. Both of these measures of profitability help a business gauge whether various product lines are financially worthwhile, and whether the company as a whole is profitable or not.
By analyzing the COGS from previous periods, businesses plan budgets and make assumptions about how costly it might be to continue producing a product line. COGS aids in production planning and employee scheduling. Accountants compare a business’s projected spending to what it actually spent, determine what caused disparities, and project costs for the next period.
The costs embedded in COGS fluctuate constantly, which has a direct impact on inventory valuation. Companies use first-in, first-out (FIFO) accounting when older inventory must be sold first, such as grocery stores or any business selling perishable goods. Last-in, first-out (LIFO) accounting is used by companies facing severe inflation or the need to control taxable income. The average-cost method uses the number of goods in inventory at the beginning of a given period and takes the number of goods sold to get an average cost for every item.
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Cost of goods sold example
Cogswell Cogs resells high-tech machinery parts. At the beginning of the year, Cogswell has ten unsold dynamos in inventory that had been purchased for $400,000 each. It also bought two late-model dynamos for $500,000 a piece. In the month of January, the company sells one late-model dynamo and two older dynamos. A simple COGS calculation for January would be beginning inventory ($4.0 million) + purchases ($1.0 million) – ending inventory ($3.7 million) = COGS of $1.3 million. Under FIFO accounting, the company’s accountants would assume the older dynamos were sold first, while under LIFO accounting, they would assume the newer dynamos were sold first.