# Cost of Goods Sold (COGS) Explained With Methods to Calculate It

> **Definition**
>
> Cost of Goods Sold refers to the direct costs associated with producing the goods that a company sells, while excluding indirect expenses like distribution and sales costs.

## What Is Cost of Goods Sold (COGS)?

Cost of goods sold (COGS) represents the [direct costs](https://www.investopedia.com/terms/d/directcost.asp) of manufacturing or purchasing the products a company sells, such as materials and labor. It excludes indirect expenses, such as distribution costs and sales force costs.

Cost of goods sold is also referred to as "cost of sales."

### Key Takeaways

*   Cost of goods sold (COGS) includes all of the costs and expenses directly related to the production of goods.
*   COGS excludes indirect costs such as overhead and sales and marketing.
*   COGS is deducted from revenues (sales) in order to calculate gross profit and gross margin. Higher COGS results in lower margins.
*   The value of COGS will change depending on the accounting standards used in the calculation.
*   COGS differs from operating expenses (OPEX) in that OPEX includes expenditures that are not directly tied to the production of goods or services.

![COGS](https://www.investopedia.com/thmb/PGHaYv8mmNPN7SghXDiKfE8m4rA=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/Cost-of-Goods-Sold-COGS-60d335925dd14754a278392cae907b92.png)

*A low Cost of Goods Sold (COGS) indicates higher profit margins. — Investopedia / Xiaojie Liu*

## Why Is Cost of Goods Sold (COGS) Important?

COGS is an important metric on financial statements as it is subtracted from a company’s revenues to determine its [gross profit](https://www.investopedia.com/terms/g/grossprofit.asp). Gross profit is a profitability measure that evaluates how efficient a company is in managing its labor and supplies in the production process.

Because COGS is a [cost of doing business](https://www.investopedia.com/articles/pf/09/business-startup-costs.asp), it is recorded as a business expense on income statements. Knowing the cost of goods sold helps analysts, investors, and managers estimate a company’s bottom line. If COGS increases, net income will decrease. While this movement is beneficial for income tax purposes, the business will have less profit for its shareholders. Businesses thus try to keep their COGS low so that net profits will be higher.

## What Is Included in the Cost of Goods Sold (COGS)?

Cost of goods sold (COGS) is the [cost of acquiring or manufacturing the products](https://www.investopedia.com/ask/answers/101314/what-are-differences-between-operating-expenses-and-cost-goods-sold-cogs.asp) or finished goods that a company then sells during a period, so the only costs included in the measure are those that are directly tied to the production of the products, including the [cost of labor](https://www.investopedia.com/terms/c/cost-of-labor.asp), materials, and manufacturing overhead.

For example, COGS for an automaker would include [the material costs](https://www.investopedia.com/ask/answers/062415/which-financial-statement-does-company-list-its-raw-material-costs.asp) for the parts that go into making the car plus the labor costs used to put the car together. The cost of sending the cars to dealerships and the cost of the labor used to sell the car would be excluded.

Furthermore, costs incurred on the cars that were not sold during the year will not be included when calculating COGS, whether the costs are direct or indirect. In other words, COGS includes the direct cost of producing goods or services that were purchased by customers during the year. As a rule of thumb, if you want to know if an expense falls under COGS, ask: "Would this expense have been an expense even if no sales were generated?"  

> **Important**
>
> COGS only applies to those costs directly related to producing goods intended for sale.

## What Is the Cost of Goods Sold (COGS) Formula?

$\begin{aligned} &\text{COGS}=\text{Beginning Inventory}+\text{P}-\text{Ending Inventory}\\ &\textbf{where}\\ &\text{P}=\text{Purchases during the period}\\ \end{aligned}$

Inventory that is sold appears in the [income statement](https://www.investopedia.com/terms/i/incomestatement.asp) under the COGS account. The beginning inventory for the year is the inventory left over from the previous year—that is, the [merchandise](https://www.investopedia.com/ask/answers/102714/what-are-differences-between-income-statements-merchandising-companies-vs-service-companies.asp) that was not sold in the previous year.

Any additional productions or purchases made by a manufacturing or retail company are added to the beginning inventory. At the end of the year, the products that were not sold are subtracted from the sum of beginning inventory and additional purchases. The final number derived from the calculation is the cost of goods sold for the year.

On a company's balance sheet, inventory appears under the section called current assets. The balance sheet provides a snapshot of a company's finances at the end of an accounting period; therefore, any inventory figure on a balance sheet represents the company's ending inventory for that specific accounting period.

## What Are the Different Accounting Methods for COGS?

The value of the cost of goods sold depends on the inventory valuation method adopted by a company. There are three methods that a company can use when recording the level of inventory sold during a period: [first in, first out (FIFO)](https://www.investopedia.com/ask/answers/052915/how-can-firstin-firstout-fifo-method-be-used-minimize-taxes.asp), last in, first out (LIFO), and the average cost method. The special identification method is used for high-ticket or unique items.

### FIFO Method

The earliest goods to be purchased or manufactured are sold first. Since prices tend to go up over time, a company that uses the [FIFO](https://www.investopedia.com/terms/f/fifo.asp) method will sell its least expensive products first, which translates to a lower COGS than the COGS recorded under LIFO. Hence, the [net income](https://www.investopedia.com/terms/n/netincome.asp) using the FIFO method increases over time.

### LIFO Method

[LIFO](https://www.investopedia.com/terms/l/lifo.asp) is where the latest goods added to the inventory are sold first. During periods of rising prices, goods with higher costs are sold first, leading to a higher COGS amount. Using this method, the net income tends to decrease over time.

### Average Cost Method

The average price of all the goods in stock, regardless of purchase date, is used to value the goods sold. Taking the [average product cost](https://www.investopedia.com/terms/a/averagecostmethod.asp) over a time period has a smoothing effect that prevents COGS from being highly impacted by the extreme costs of one or more acquisitions or purchases.

### Special Identification Method

The special identification method uses the specific cost of each unit of merchandise (also called inventory or goods) to calculate the ending inventory and COGS for each period. In this method, a business knows precisely which item was sold and [the exact cost](https://www.investopedia.com/ask/answers/101314/what-are-main-methods-calculating-business-costs.asp). This method is typically used in industries that sell unique items like cars, real estate, and rare and precious jewels.

## What Type of Companies Are Excluded From a COGS Deduction?

Many service companies don’t report any cost of goods sold (COGS) because they don’t sell physical products. Under [generally accepted accounting principles (GAAP)](https://www.investopedia.com/terms/g/gaap.asp), COGS refers only to the cost of inventory items sold during a given period. Since purely service-based businesses typically don’t hold inventory, they have no COGS to report. If a company’s income statement doesn’t list COGS, there is no deduction for those costs.

Examples of pure service companies include accounting firms, law offices, real estate appraisers, business consultants, and professional dancers, among others. Even though all of these industries have business expenses and normally spend money to provide their services, they do not list COGS. Instead, they have what is called "cost of services," which does not count towards a COGS deduction.

## Cost of Revenue vs. COGS

[Costs of revenue](https://www.investopedia.com/terms/c/cost-of-revenue.asp) exist for ongoing contract services that can include raw materials, direct labor, shipping costs, and commissions paid to sales employees. These items cannot be claimed as COGS without a physically produced product to sell, however. The IRS website even lists some examples of "personal service businesses" that do not calculate COGS on their income statements. These include doctors, lawyers, carpenters, and painters.

Many service-based companies have some products to sell. For example, airlines and hotels are primarily providers of services such as transport and lodging, respectively, yet they also sell gifts, food, beverages, and other items. These items are definitely considered goods, and these companies certainly have inventories of such goods. Both of these industries can list COGS on their income statements and claim them for tax purposes.

## Operating Expenses vs. COGS

Both [operating](https://www.investopedia.com/terms/o/operatingratio.asp) expenses and cost of goods sold (COGS) are expenditures that companies incur with running their business; however, the expenses are segregated on the income statement. Unlike COGS, [operating expenses (OPEX)](https://www.investopedia.com/ask/answers/040915/what-are-different-types-operating-expenses.asp) are expenditures that are not directly tied to the production of goods or services.

Typically, [SG&A (selling, general, and administrative expenses](https://www.investopedia.com/terms/s/sga.asp)) are included under operating expenses as a separate line item. SG&A expenses are expenditures, such as overhead costs, that are not directly tied to a product. Examples of operating expenses include the following:

*   Rent
*   Utilities
*   Office supplies
*   Legal costs
*   Sales and marketing
*   Payroll
*   Insurance costs

## What Is the Difference Between Cost of Sales and Cost of Goods Sold?

While these terms are often used interchangeably, there's a subtle [difference between the two](https://www.investopedia.com/ask/answers/112614/whats-difference-between-cost-goods-sold-cogs-and-cost-sales.asp). COGS specifically refers to the direct costs associated with producing goods or acquiring inventory that has been sold during a particular period. By contrast, COS includes not only the direct costs of goods sold but also other costs directly related to generating revenue, such as direct labor and direct overhead. Essentially, COS encompasses a broader range of expenses than COGS, as it may include additional costs associated with delivering the product or service to the customer.  

## What Are the Limitations of COGS?

COGS can easily be manipulated by accountants or managers looking to cook the books. It can be altered by:

*   Allocating to inventory higher manufacturing overhead costs than those incurred
*   Overstating discounts
*   Overstating returns to suppliers
*   Altering the amount of inventory in stock at the end of an accounting period
*   Overvaluing inventory on hand
*   Failing to write off obsolete inventory

When inventory is artificially inflated, COGS will be under-reported, which, in turn, will lead to a higher-than-actual [gross profit margin](https://www.investopedia.com/ask/answers/010915/what-costs-are-not-counted-gross-profit-margin.asp) and hence, an inflated net income.

Investors looking through a company’s financial statements can spot unscrupulous inventory accounting by checking for inventory buildup, such as inventory rising faster than revenue or total assets reported.

## How Do You Calculate Cost of Goods Sold (COGS)?

Cost of goods sold (COGS) is calculated by adding up the various direct costs required to generate a company’s revenues. Importantly, COGS is based only on the costs that are _directly_ utilized in producing that revenue, such as the company’s inventory or labor costs that can be attributed to specific sales. By contrast, fixed costs such as managerial salaries, rent, and utilities are not included in COGS. Inventory is a particularly important component of COGS, and accounting rules permit several different approaches for how to include it in the calculation.

## What Is Included in the Cost of Goods Sold?

Cost of Goods Sold represents the direct costs attributable to the production of goods sold by a company. It includes various costs directly associated with the production or acquisition of the goods that a company sells during a specific period. These costs typically include:

*   Direct materials
*   Direct labor
*   Manufacturing overhead
*   Freight and shipping costs (but not the cost of shipping products to customers)
*   Direct costs of production

## Are Salaries Included in COGS?

COGS does not include salaries and other general and administrative expenses; however, certain types of labor costs can be included in COGS, provided that they can be directly associated with specific sales. For example, a company that uses contractors to generate revenues might pay those contractors a commission based on the price charged to the customer. In that scenario, the commission earned by the contractors might be included in the company’s COGS, since that labor cost is directly connected to the revenues being generated.

## How Does Inventory Affect COGS?

In theory, COGS should include the cost of all inventory that was sold during the accounting period. In practice, however, companies often don’t know exactly which units of inventory were sold. Instead, they rely on accounting methods such as the first in, first out (FIFO) and last in, first out (LIFO) rules to estimate what value of inventory was actually sold in the period. If the inventory value included in COGS is relatively high, then this will place downward pressure on the company’s gross profit. For this reason, companies sometimes choose accounting methods that will produce a lower COGS figure, in an attempt to boost their reported profitability.

## The Bottom Line

Cost of goods sold is the direct cost of producing a good, which includes the cost of the materials and labor used to create the good. Because COGS is subtracted from revenue to calculate gross profit, it has a direct impact on a company’s bottom line. Managing COGS is critical: negotiating better supplier prices or improving production efficiency can lower COGS and boost profitability.

> **Article Sources**
>
> 1.  Internal Revenue Service. "[Publication 535 (2022), Business Expenses](https://www.irs.gov/publications/p535#en_US_2020_publink100078332)."
>     
> 2.  Mitchell Franklin, Patty Graybeal, and Dixon Cooper. "[Principles of Accounting, Volume 1: Financial Accounting](https://d3bxy9euw4e147.cloudfront.net/oscms-prodcms/media/documents/FinancialAccounting-OP_dwsQeqn.pdf)," Pages 373 and 407.
>     
> 3.  Mitchell Franklin, Patty Graybeal, and Dixon Cooper. "[Principles of Accounting, Volume 1: Financial Accounting](https://d3bxy9euw4e147.cloudfront.net/oscms-prodcms/media/documents/FinancialAccounting-OP_dwsQeqn.pdf)," Pages 652-654.
>     
> 4.  Internal Revenue Service. "[Publication 334: Tax Guide for Small Business](https://www.irs.gov/pub/irs-pdf/p334.pdf)," Page 27.
>     
> 5.  Mitchell Franklin, Patty Graybeal, and Dixon Cooper. "[Principles of Accounting, Volume 1: Financial Accounting](https://d3bxy9euw4e147.cloudfront.net/oscms-prodcms/media/documents/FinancialAccounting-OP_dwsQeqn.pdf)," Page 405.
>     
> 6.  Internal Revenue Service. "[Publication 334: Tax Guide for Small Business](https://www.irs.gov/pub/irs-pdf/p334.pdf)," Pages 28-29.