What is COGS and How Does It Impact Gross Profit?
How do managers know if they have set prices correctly? How do financial analysts determine if the production cost of a company is viable? Out of the many metrics available, COGS and Gross Profit are two measures that can give us direct information about a company’s financial status. But what do those two metrics mean and how can they be interpreted? Let’s find out!
What is COGS?
COGS, short for Cost Of Goods Sold, is a measure of the costs of a firm that are directly connected with its production process. The most common examples of COGS are purchases of raw materials, parts used in manufacturing and wages of workers directly involved in the assembly of goods. Furthermore, items bought for direct resale without being further processed in any way are also considered COGS. For example, the cost incurred by a local store through buying fresh vegetables from a farmer to sell them to retail customers are considered COGS for the retail business.
Are all business expenses to be considered COGS?
No, for an expense to fall into the category of cost of goods sold it must be directly attributed to the making of a specific product. All other everyday expenses of a business that are not directly related to the production process and that may have been incurred even if the business made zero sales, such as administrative expenses, marketing expenses, rent, R&D costs, and energy bills are considered OPerating EXpenses, which we explored previously.
What about goods produced but not sold?
The Costs of Goods Sold account comprises only the costs of the products that were actually sold. This is because COGS is usually examined along with Revenue (Sales) generated by selling those goods. Therefore, COGS may include costs of goods produced (or bought to be resold) during a previous year but being sold now. On the other hand, costs of goods produced but not sold are recorded as inventory costs, which incur as Inventory on the Balance Sheet, as we’ve already shown.
How is COGS calculated?
Now that we have defined what costs are included in COGS we can proceed to find out how we can calculate it. There are, in fact, two ways to perform this calculation. The first one is more direct, and it is simply the addition of all costs of goods sold. This way may be straightforward, but it is rather impractical, as you would have to keep track of each and every one of a firm’s sales.
The second way of calculating the cost of goods sold for a given period is by using the following formula:
COGS= I_S + G - I_E
IStart (IS) is the inventory balance at the beginning of the period,
G is the cost of goods produced during the period, and
IEnd (IE) is the cost of goods produced but not sold and therefore left in the inventory balance at the end of the period.
Let’s consider an example:
A car manufacturer had produced 20 cars at $5.000 each in the course of the previous year but didn’t manage to sell any of them. During this year the company produced 10 more cars at the same cost. At the end of the current year, the company is left with five cars.
By applying the above formula:
IStart: 20 \times \$5,000 = \$100,000
G: 10 \times \$5,000 = \$50,000
IEnd: 5 \times \$5,000= \$25,000
COGS: \$100,000+\$50,000-\$25,000 = \$125,000
Therefore, the cost of cars sold this year is $125,000.
In practice, however, different products may have different costs of production and it is difficult to track which product has left inventory and been sold. To keep COGS calculations simple there have been developed some accounting principles for companies to choose from:
1. FIFO (First in First Out): under this principle, the first good to be produced is assumed to be the first to leave the inventory.
2. LIFO (Last in first out): under this principle, the last good to be produced is the first to be sold.
3. Average cost: Under this principle, the goods sold are assumed to have a production cost equal to the average cost of all goods sold.
Different principles may lead to different COGS, so we must always keep an eye for which principle a company used!
Why Do We Use COGS?
As a measure of production cost, COGS helps managers set correct prices for their products in order to generate enough revenue to cover those costs. Should a manager set prices too low, then COGS may exceed Revenue, thus leading to losses. Furthermore, analysts examine COGS to consider whether a firm produces a product competitively (compared to a similar firm.) A good way to examine the impact of COGS on a firm is in conjunction with Gross Profit.
Let’s return to our example of the car manufacturing company. The total units sold by our company during the course of this year is: 20 (made the previous year but sold this year) + 10 (made and sold this year) – 5 (left in inventory) = 25 units
If the company sold each of these cars at $6000 each, its total Revenue would be: 25 x $6000 = $150,000
Gross Profit = Total Revenue - COGS
So, our company’s Gross Profit comes at $150,000 – $125,000 = $25,000. Of course, there are a few other expenses to consider before we can arrive at the Net Income of a company and get a full picture of its economic performance. But for now we can say that our car company is on a good track! Its products are well priced and it has a good chance of continuing to compete on the market.
In a different scenario, higher COGS could lead to lower Gross Profit, which would increase the likelihood of ending up with losses after other operational and non-operational expenses are subtracted. The same applies when we examine a firm’s performance dynamically over time, like when COGS increases faster than Gross Profit on an annual basis, which means that the extra goods sold produce less and less revenue for the firm.
COGS and Gross Profit are both measures of a firm’s competitiveness and profitability. However, while examining these two variables can provide meaningful insights, many other parameters have to be considered to determine whether or not a firm is profitable and competitive.
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