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If you've done research on evaluating financial performance in a business you have most likely come across the term COGS. You've also probably run into some opposing viewpoints as to what actually makes up COGS. Some of these disagreements might even be between bookkeepers or accounting professionals. So what is it and why is it important?
COGS stands for Cost of Goods Sold. The easiest way to think about it is a retail store selling product for a profit. Let's say they pay $10 for the product and sell it at $25. Their Cost of Goods Sold is $10. Seems simple enough right? Well there's actually far more that can go into COGS than the cost of inventory. And this concept is where a lot of the confusion comes in.
Cost of Goods Sold by definition is all of the costs that directly go into creating and/or providing a product or service. These costs can directly be tied to the actual activity or product that is making the company money. When we talk in terms of cost accounting COGS is composed of direct materials, direct labor, and manufacturing overhead.
Let's look at an example:
ABC Inc manufactures garden fencing. They purchase raw materials from their suppliers and put these components together to create their products. When ABC Inc records expenses they will put a couple of types of expenses into a COGS account. These include the materials that are going directly into their products, the payroll expenses associated with labor that is directly tied to the manufacturing of their product, and the overhead tied to the manufacturing process. Manufacturing overhead includes things like utilities associated with the manufacturing plant. ABC Inc can have multiple accounts/expense categories that are COGS accounts. They don’t all need to go into a single COGS account.
Why The Confusion?
So why is there so much confusion around what makes up COGS? The easiest concept to understand is allocating the cost of products and direct supplies to COGS. It can be a harder concept to understand that labor and manufacturing overhead goes into COGS. And the cost accounting breakdown of COGS is not actively taught in basic bookkeeping courses. Because of this COGS is oftentimes seen as only being a category you use in business selling products, not services. This is not technically accurate.
So What Should a Small Business Do? Small businesses should allocate direct labor and manufacturing overhead to COGS accounts when the allocation process costs less to implement than the benefits it provides. In other words if these expenses can be easily identified they should be allocated to COGS accounts. If they cannot be easily identified the business owner and other decision makers need to determine if the process of determining what those expenses are is worth the financial insight it provides.
Why is COGS Important?
COGS is extremely important in the financial analysis of a business. COGS generally fluctuates based on the amount of sales. Revenue minus COGS is gross profit. A negative gross profit means that the actual process of providing the services or selling the products is not profitable. Whereas a positive gross profit, but a negative net income points to a potential problem with overhead costs or sales volume as related to overhead. Gross profit percentage is calculated by taking gross profit and dividing it by revenue. This is the percentage of revenue that is left over after the cost of providing the services/creating or purchasing the products is paid for. A low gross profit percentage points to an unsustainable pricing structure or costs associated with fulfilling sales. Gross profit percentage will vary by industry, it‘s best to compare to an industry average.
COGS is a basic, but very important, calculation that affects a number of other KPIs. Understanding how COGS works is critical in evaluating the health of a business.