'Cost of Goods Sold (COGS)' is explained in detail and with examples in the Corporate Finance edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.
The Cost of Goods Sold refers to those costs which directly arise from the creation of a firm’s goods or services. The phrase also sometimes is summarized by its acronym COGS or by an alternative name the “cost of sales.” It will cover many expenses. Among these are all of the materials the company utilizes to physically produce the goods.
It also considers the labor expenses employed to create the items. It will not include expenses that are considered to be indirect. This means that sales force and distribution expenses will not be taken into account. COGS shows up on income statements. Accountants and economists can utilize it to subtract it out from the given company’s revenues in order to establish the firm’s gross margin.
Every business has the ultimate goal to earn profits at the heart of what it is doing. This is why a less expensive goods production for their product or service will lead to higher profits, all else being equal. A fuller explanation of what the Cost of Goods Sold includes involves inventory, materials, labor, factory equipment for production, and even overhead. All of these factors of production directly pertain to the goods or services the company produces. The calculation also takes into consideration the freight or shipping of inputs utilized. It would never include associated costs like rent for a facility or general payrolls of a company.
Looking at an example helps to clarify the Cost of Goods Sold concept. Where an automobile manufacturer is concerned, there will be a number of material costs. Chief among these would be those parts that actually combine to produce the car, as well as the cost of labor for assembling the car. The COGS would not include the cost of the sales force personnel which actually sell the car nor the price for getting the cars out to the dealership. Both of these last ideas are post-production costs, so they are not a part of the primary COGS.
There are a number of different ways for calculating the Cost of Goods Sold. It also varies from one certain kind of business to those in another industry. Among the most simple means of figuring this number out is to start with the costs of inventory over the production period. Next they would add in the aggregate purchase amounts in the same time frame. They would likely then subtract out the inventory at the end of production point. Such a calculation will provide the literal cost of the inventory which the company produced in a given time frame.
Another example helps to make the explanation clearer. Assume that a firm begins its production phase with $15 million worth of inventory. If they make $3 million in additional purchase in this time and end the production period with $14 million of inventory, then the firm’s Cost of Goods Sold is calculated by taking the $15 million and adding in the $3 million in purchases and subtracting out the final $14 million in remaining inventory. This gives a final COGS of $15M plus $3M minus $14M for a final result of $4M.
The significance to this formula and Cost of Goods Sold figure is important. The COGS reveals how effectively the firm is able to convert its inventory into revenues and profits. This is why it is critical to compare the COGS against the revenue of the period under consideration. When the company above had a revenue exceeding $4 million, then it would boast a gross profit that was positive. If the revenue of the firm in question was less than the $4 million COGS, then there would be a negative gross profit. In other words, understanding and knowing the COGS figure for a company tells investors which companies are ultimately successful and which are in financial trouble, assuming that state of (negative profit) affairs continues for long.