COGS is an abbreviation of the term cost of goods sold. The cost of goods sold includes the costs of all items that are directly or indirectly associated with the production or purchase of goods that have been sold. The main categories of costs included in COGS are:
- Direct materials
- Direct labor
- Factory overhead
- Production supplies
Only the direct materials cost is a variable cost that fluctuates with revenue levels, and so is an undisputed component of the cost of goods sold. Direct labor can be considered a fixed cost, rather than a variable cost, since a certain amount of staffing is required in the production area, irrespective of production levels.
Nonetheless, direct labor is considered a part of the cost of goods sold. Factory overhead is a largely fixed cost, and is allocated to the number of units produced in a period. Selling and administrative costs are not included in the cost of goods sold; instead, they are charged to expense as incurred.
There are several ways to calculate COGS. At the least accurate level, it can be a simple calculation of adding purchases to beginning inventory and then subtracting ending inventory, though that approach requires an accurate ending inventory count. A more accurate method is to track each inventory item as it moves through the warehouse and production areas, and assign costs at a unit level.
COGS can also be impacted by the cost flow assumption used by a business. If a company follows the first in, first out methodology, it assigns the earliest cost incurred to the first unit sold from stock. Conversely, if it uses the last in, first out methodology, it assigns the last cost incurred to the first unit sold from stock. There are several variations on these cost flow assumptions, but the point is that the calculation methodology used can alter the cost of goods sold.
COGS is recognized in the same period as the related revenue, so that revenues and related expenses are always matched against each other (the matching principle); the result should be recognition of the proper amount of profit or loss in an accounting period.
The cost of goods sold is positioned midway in the income statement, immediately after all revenue line items, and prior to general, selling, and administrative expenses.
The COGS figure is frequently used as a subtraction from revenue, to arrive at the gross margin ratio. This ratio is measured on a trend line basis to see if a company is maintaining its price points and manufacturing or purchasing costs in a manner that maintains its ability to generate a profit.
A variation on the COGS concept is to only include variable costs in it, which results in a calculated contribution margin when the variable costs are subtracted from revenues. This approach pushes fixed costs further down in the income statement.