What Is Cost of Goods Sold (COGS)?
Cost of Goods Sold (COGS) represents the direct costs attributable to the production or acquisition of goods sold by a company. It includes raw materials, direct labor, and manufacturing overhead directly tied to production. COGS is subtracted from revenue to calculate gross profit, making it one of the most important line items on the income statement.
Understanding COGS is essential for pricing decisions, profitability analysis, and tax reporting. The IRS requires businesses that sell products to calculate COGS for tax purposes. Accurately tracking COGS ensures your gross margin reflects true production efficiency.
COGS includes only DIRECT costs of production: materials, direct labor, factory overhead. It does NOT include selling expenses, administrative costs, or marketing. Those are operating expenses and affect operating margin, not gross margin.
COGS Formulas
- 1COGS = $50,000 + $120,000 - $45,000 = $125,000
- 2Gross Profit = $250,000 - $125,000 = $125,000
- 3Gross Margin = $125,000 / $250,000 = 50%
- 4COGS as % of Revenue = $125,000 / $250,000 = 50%
What Is Included in COGS?
| Business Type | Included in COGS | NOT Included in COGS |
|---|---|---|
| Manufacturer | Raw materials, direct labor, factory rent, equipment depreciation | Admin salaries, marketing, office rent |
| Retailer | Purchase cost of inventory, freight-in, import duties | Store rent, cashier wages, advertising |
| Service Business | Direct labor for services, materials consumed | Overhead, admin, sales costs |
| E-commerce | Product cost, packaging, inbound shipping | Website hosting, marketing, customer service |
Inventory Valuation Methods
- FIFO (First In, First Out): Oldest inventory costs are used for COGS first. Results in lower COGS during inflation.
- LIFO (Last In, First Out): Newest costs used first. Results in higher COGS during inflation, reducing taxable income. Not allowed under IFRS.
- Weighted Average: Average cost of all inventory used for COGS. Smooths cost fluctuations.
- Specific Identification: Each item tracked individually. Used for high-value, unique items (jewelry, cars, real estate).
How to Calculate COGS Accurately
The IRS requires businesses with inventory to use an accrual method for COGS. Your choice of inventory valuation method (FIFO vs. LIFO) directly affects taxable income. LIFO reduces COGS taxes during inflation but is not reversible once elected. Consult a tax professional before choosing.