Cost of Goods Sold

Cost of Goods Sold: Definition, Calculation & Importance 

While tracking revenue is crucial for assessing eCommerce success, it is equally vital not to overlook the significance of Cost of Goods Sold (COGS). Discover why COGS holds paramount importance in the following article.

What is the Cost of Goods Sold? 

In the realm of eCommerce, Cost of Goods Sold (COGS) serves as a critical metric that measures the direct costs associated with producing goods or services. It includes material costs, direct labor costs, and direct factory overhead, all of which are directly correlated to revenue. When a company experiences an increase in sales, the demand for resources in the production process increases.

On an eCommerce-specific income statement, COGS typically appears as the second line item immediately after revenue. It functions as a deduction from revenue and provides insight into gross profit.

For eCommerce businesses, the components of COGS include the full range of costs associated with producing goods or providing services. These include variable costs such as raw materials and labor used to produce goods. In addition, fixed costs such as factory overhead, warehousing, and, depending on applicable accounting policies, depreciation may be included.

It is important to note that COGS in eCommerce excludes general selling expenses such as management salaries and advertising costs. These are clearly shown below the gross profit line and fall under selling, general, and administrative (SG&A) expenses.

How is Cost of Goods Sold Calculated? 

The Cost of Goods Sold (COGS) formula may seem simple at first glance, involving three variables: beginning inventory, purchases, and ending inventory. Here is the formula for calculating COGS:

COGS = (Beginning Inventory + Purchases) − Ending Inventory COG

Four Steps to Calculate COGS:

  1. Identify Beginning Inventory: Determine the beginning inventory levels of raw materials, work-in-process, and finished goods based on the previous year's ending inventory levels.
  2. Determine Purchases Cost: Calculate the cost of raw material purchases made during the period, considering factors such as freight, trade, and cash discounts.
  3. Determine Ending Inventory: Determine the ending inventory balance, often through physical cycle counts. This process is consistent with the company's chosen inventory valuation method.
  4. Include Direct Production Costs: Ensure that any additional direct costs associated with production are included in the inventory valuation.

While the basic formula provides a snapshot, these steps provide a more nuanced understanding. Typically performed by accounting and tax professionals, this process is essential for managers to understand and contribute to informed decision making within the organization.

Why is Cost of Goods Sold Important? 

The cost of goods sold can be important for several reasons. Here are some of them:

  1. Gross Profit Determination: COGS is a key metric that is subtracted from a company's revenue to calculate gross profit. This metric measures the company's efficiency in managing labor and materials during the production process.
  2. Expense Recording: As a fundamental cost of doing business, COGS is recorded as an operating expense on the income statement. This ensures an accurate representation of the company's financial health.
  3. Profitability Estimation: Knowledge of COGS is critical for analysts, investors, and managers to assess a company's bottom line. An increase in COGS results in a decrease in net income, which affects overall profitability.
  4. Tax Implications: While an increase in COGS can be beneficial for income tax purposes, it reduces the profits available to shareholders. Companies seek to keep COGS low in order to optimize net income.
  5. Focused Cost Inclusion: COGS includes only costs directly related to the production of goods, such as labor, materials, and manufacturing overhead. It excludes selling expenses and other indirect costs.
  6. Exclusion of Unsold Inventory Costs: Costs related to unsold products, whether direct or indirect, are excluded from the calculation of COGS. This ensures a focus on the direct cost of goods or services purchased by customers during the year.
  7. Guiding Expense Classification: A rule of thumb for classifying expenses under COGS is to ask whether the expense would continue even in the absence of the sales generated.

Cost of Revenue vs COGS 

Cost of Revenue incurred for ongoing contract services and include components such as raw materials, direct labor, shipping costs and sales commissions. However, these cannot be classified as COGS unless there is a physically produced product for sale. Certain service-based businesses, such as doctors, lawyers, carpenters, and painters, are excluded from calculating COGS on their income statements, according to the IRS.

On the other hand, COGS (cost of goods sold) is specific to businesses with physically produced products for sale. Industries that primarily provide services, such as airlines and hotels, can report COGS on income statements for items such as gifts, food and beverages. COGS becomes a tax-deductible expense when there is a tangible inventory of goods. This distinction ensures accurate financial reporting and appropriate tax considerations based on the nature of a company's offerings.

Cost of Goods Sold: Key Takeaways 

  • In eCommerce, Cost of Goods Sold (COGS) is a crucial metric, measuring direct costs tied to goods or services production. It encompasses material and labor costs, directly proportional to revenue, providing insights into gross profit. It excludes general sales expenses, maintaining a focus on production costs.
  • Calculating COGS involves four essential steps. From identifying beginning inventory to determining ending inventory and including direct production costs, this process requires attention to detail. These steps offer a nuanced understanding, contributing to informed decision-making within organizations.
  • COGS is pivotal for several reasons. It determines gross profit, reflecting a company's efficiency in managing production resources. As an operating expense, COGS is crucial for accurate financial representation. Analysts, investors, and managers use COGS to estimate a company's profitability, considering its impact on net income. Additionally, COGS includes only direct production costs, excluding unsold inventory costs and guiding expense classification. Understanding COGS is essential for optimizing net income and ensuring accurate financial reporting.

Back to