Cost of goods sold (COGS)

Definition

Cost of goods sold (COGS) refers to the direct costs attributable to the production of the goods that a company sells during a specific period. This includes the cost of materials, labor, and overhead directly tied to the manufacturing process. Understanding COGS is essential for determining a company's gross profit, as it directly impacts the income statement and reflects how efficiently a company is managing its production costs.

5 Must Know Facts For Your Next Test

1. COGS is calculated using either the FIFO (First In, First Out) or LIFO (Last In, First Out) inventory accounting methods, affecting financial reporting and tax liabilities.
2. A decrease in COGS can indicate improved efficiency in production or reduced material costs, positively impacting gross profit margins.
3. Companies must carefully manage their inventory levels since excess inventory can lead to higher COGS due to increased storage and spoilage costs.
4. COGS does not include indirect expenses such as selling and administrative costs, which are categorized separately on the income statement.
5. COGS is a crucial factor for investors and analysts when assessing a company's profitability and overall financial health.

Review Questions

• How does COGS influence gross profit on the income statement?
  • COGS directly affects gross profit by determining the total cost associated with producing goods that were sold during a specific period. Gross profit is calculated by subtracting COGS from total revenue. Therefore, any changes in COGS will directly impact gross profit; lower COGS results in higher gross profit, while higher COGS reduces gross profit, highlighting the importance of efficient cost management.
• In what ways can a company's inventory management strategies affect its COGS and overall profitability?
  • Effective inventory management strategies can significantly impact COGS by ensuring that production levels align with sales demand. For example, implementing just-in-time (JIT) inventory can reduce excess stock, minimizing storage costs and waste. Conversely, poor inventory management can lead to overproduction or stockouts, resulting in increased COGS through higher material costs or missed sales opportunities. Thus, sound inventory practices contribute to maintaining a favorable COGS and enhancing profitability.
• Evaluate how changes in raw material prices can affect a company's COGS and its subsequent impact on financial performance.
  • Changes in raw material prices have a direct impact on a company's COGS, as these costs are factored into production expenses. An increase in raw material prices raises COGS, potentially squeezing profit margins if the company cannot pass these costs onto customers through higher sales prices. This situation may lead to decreased net income and could affect investment attractiveness. Conversely, falling raw material prices reduce COGS, potentially improving profitability and providing more flexibility for competitive pricing strategies.

Related terms

Gross Profit: The difference between revenue and COGS, representing the amount available to cover operating expenses and generate profit.

Inventory:

The goods and materials a business holds for the purpose of resale, which impacts COGS when items are sold.

Operating Expenses:

The costs required to run a business that are not directly tied to the production of goods, which, along with COGS, are deducted from revenue to determine net income.