What is COGS? Inclusions, Exclusions and Common Mistakes

Introduction

What is COGS?

Cost of Goods Sold (COGS) is simply how much it costs a business to make or buy the products it sells during a certain time. This includes things like raw materials and the wages paid to workers directly making the product, but not costs like marketing or office expenses. Calculating COGS helps businesses determine their gross profit and understand how efficiently they are managing production and inventory.

Why is COGS Important?

Cost of Goods Sold (COGS) plays a fundamental role in determining a business's financial performance, particularly its gross profit. By subtracting COGS directly from revenue, a business can clearly see how much money it has made after covering all the direct costs associated with producing or acquiring the goods it sold. This immediate insight into core profitability is crucial for assessing operational efficiency.

Beyond historical reporting, COGS is also an invaluable tool for strategic planning, budgeting, and predicting future financial trends. Businesses meticulously track COGS to inform their pricing strategies, ensuring that products are priced competitively yet profitably. It's also vital for monitoring and improving cost-efficiency in production and supply chain management.

For external stakeholders, particularly investors and financial analysts, understanding COGS is key to evaluating a company's financial health and operational leverage. A lower COGS relative to revenue often signals higher profitability and effective cost control, making the company more attractive to potential investors. Conversely, an increasing COGS can indicate rising production costs or inefficiencies, prompting further investigation.

What Is Included in the Cost of Goods Sold (COGS)?

Direct Materials

These are the raw inputs that go into creating a finished product. For example, in the case of a shoe manufacturer, this would include materials like leather, rubber soles, fabric, thread, and laces. Making more products means spending more on materials.

Direct Labour

This refers to the wages paid to workers who are physically involved in making the product. It includes assembly line workers, machine operators, and packagers. It does not include salaries for managers, supervisors, or administrative staff.

Manufacturing Supplies

These are things we use up while making a product, but they don't actually end up in the finished item. Examples include lubricants for machines, cleaning supplies used in the workshop, or disposable tools used in manufacturing.

Freight-In Costs

These are the costs a company pays to transport raw materials or goods from suppliers to its own production facility. This can include trucking fees, customs duties, and handling charges, all of which are necessary to make the materials available for use.

Cost of Revenue vs. COGS

Operating Expenses vs. COGS

Cost of Sales vs. Cost of Goods Sold

5 Benefits of Tracking COGS

Smarter Pricing Decisions

Understanding your COGS allows you to price your products more effectively. By knowing exactly how much each product costs to produce, you can ensure that pricing covers costs and achieves desired profit margins.

Accurate Profit Calculation

Cost of Goods Sold (COGS) is the direct determinant of a business's gross profit, making its accurate calculation absolutely critical. By meticulously tracking COGS, companies gain a precise understanding of the true profitability generated by each individual product or service sold. This granular insight is invaluable because it moves beyond top-line revenue to reveal the actual financial contribution of each item after its direct production costs are covered. With this accurate profitability data, businesses are empowered to make better, more strategic decisions regarding product development, pricing, and resource allocation, focusing efforts on their most lucrative offerings.

Improved Inventory Management

Analysing COGS in conjunction with inventory turnover rates provides powerful insights that are essential for improved inventory management. By understanding how quickly goods are sold (reflected in COGS) versus how long they sit in storage (inventory), businesses can effectively identify slow-moving or obsolete stock. This knowledge enables more informed purchasing decisions, preventing overstocking of less popular items and ensuring that capital isn't tied up unnecessarily. Ultimately, proactive inventory management driven by COGS analysis helps minimise waste, reduce carrying costs, and ensure that the right products are available at the right time.

Cost Control and Efficiency

Regular monitoring of COGS can reveal inefficiencies or cost overruns in production. This enables timely intervention to reduce waste, renegotiate supplier contracts, or optimise labour usage.

Better Forecasting and Budgeting

Historical COGS data helps businesses predict future costs and plan budgets more effectively, particularly in managing seasonality and scaling operations. This historical perspective is particularly crucial for managing seasonality, as businesses can identify recurring patterns in their production costs linked to specific times of the year (e.g., higher raw material prices during peak demand seasons, or increased labour costs during holiday rushes). Understanding these seasonal fluctuations allows for proactive inventory management, staffing adjustments, and pricing strategies to optimise profitability throughout the year.

Common Mistakes in Calculating COGS

Misclassifying Operating or Administrative Expenses as COGS

A common error is including costs like marketing, advertising, executive salaries, or office rent under COGS. These are indirect expenses and should be recorded separately under operating expenses to maintain financial accuracy.

Ignoring Inventory Adjustments

Failing to account for changes in inventory, such as damaged, lost, or unsold stock, can lead to incorrect COGS figures. This affects gross profit and could mislead investors or other interested parties.

Using the Wrong Accounting Method

Applying inconsistent inventory accounting methods (like switching between FIFO and LIFO) without clear documentation can distort COGS and affect financial comparability across periods.

Overlooking Freight and Handling Costs

Businesses sometimes exclude inbound freight or customs duties from COGS, even though these are necessary for acquiring the inventory. This can understate actual costs. While these might seem like separate expenses, they are, in fact, necessary costs directly incurred to acquire inventory and make it ready for sale.

FAQs on COGS

What is the simple meaning of COGS? COGS, or Cost of Goods Sold, is the direct cost of producing the goods a company sells, including materials and direct labour.

What is the difference between COGS and operating expenses? COGS covers the direct costs of producing goods sold, while operating expenses are indirect costs of running the business, like rent and marketing.

Is COGS the same as cost of sales? Yes, "COGS" and "Cost of Sales" are often used interchangeably to refer to the direct costs associated with producing the goods or services sold.

What items are included in cost of goods sold? Items included in COGS are direct materials, direct labour, and manufacturing overhead directly tied to production.

Are indirect costs part of COGS? No, indirect costs, such as administrative salaries or marketing expenses, are generally not part of COGS; they are usually classified as operating expenses.

How does COGS affect profit margins? COGS directly affects profit margins: lower COGS leads to higher gross profit margins, assuming sales revenue remains constant.

What happens if COGS is too high? If COGS is too high, it reduces a company's gross profit, potentially leading to lower overall profitability and financial strain.

What expenses should not be included in COGS? Expenses that should not be included in COGS are indirect costs like administrative salaries, marketing and selling expenses, and research and development costs.