Cost of Goods Sold (COGS) – Definition

Definition of cost of goods sold (COGs): Costs of a business which can be directly attributed to revenue generated during the same financial period.

Cost of goods sold (COGS) definition
Cost of goods sold (COGS) is an accounting concept

What does cost of goods sold mean

Cost of goods sold is a cost subtotal reported on the income statement, also known as the profit and loss account or statement of comprehensive income.

All expenses recorded by a company on its income statement can be divided into two groups – those which are directly connected to each sale, and those which are not.

Here’s how to quickly tell the difference. Direct costs are those which will specifically increase as a result of producing one extra good or providing one additional service. This is also known as a variable cost.

For example; burgers are a direct cost for McDonald’s, and front-of-house staff are a direct cost for a restaurant. Serving more customers will directly lead to an increase in these costs. Anything which directly contributes towards the products or service will be a direct cost.

All direct costs are reported within cost of goods sold.

Revenue less cost of goods sold gives gross profit.

Indirect expenses, on the other hand, are costs which won’t necessarily rise in line with output. The best financial accounting books will list examples such as the cost of renting the head office, the cost of staffing an accounting department, or the salaries of senior management.

Indirect expenses or overheads are then deducted from gross profit to reach operating profit – which is a more complete measure of the profitability of a company’s operations.

Capital expenditure is not reported within cost of goods sold. This is reported on the income statement as a depreciation charge as the assets bought through the capital expenditure are used.

How is the phrase ‘cost of goods sold’ used in a sentence?

Here’s how ‘cost of goods sold’ or its abbreviation might appear in a sentence:

“Cost of goods sold has risen much faster than revenue, leading to deterioration in gross margin.”

“COGS as a percentage of turnover has remained stable throughout the period, and is consistent with the budget.”

About this definition of cost of good sold (COGS)

You might be wondering what is the point of reporting direct expenses as COGS and then reporting indirect expenses below the gross profit line. If all of the expenses will ultimately be deducted from revenue to reach the bottom line, why are they split in this manner?

The reason accountants do this is because of the ‘behaviour’ of costs.

Because COGs are direct, they will probably double if revenue doubles. You could say that the two are very positively correlated.

Indirect costs will probably stay quite flat as output rises, until a company needs to expand its operations and expands to a new factory or office.

By separating these costs on the income statement, this allows a user of the financial statements to consider ‘What if?’ scenarios.

What if revenue had been 10% lower? What if turnover doubled?

These questions are easy to answer ourselves, as we now know that COGS would probably move in proportion with revenue, and the rest of the expenses will be unchanged.

How does the definition of cost of goods sold relate to investing?

If you study the strategy of value investing and wish to follow the steps set out in investing books or courses, you will need to become very familiar with the income statement and balance sheet.

With a good understanding of what each caption represents, you will be able to gain insights about the performance of a company by reading its financial statements.

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