Accounting is full of numbers and other things set in stone. Numbers are added and subtracted and multiplied and divided in accounting, and balance sheets are formed based on these calculations. One of the most commonly recognized figures in accounting is cost of goods sold (COGS).

Also called cost of sales, COGS is the total direct expenses incurred in the production of a good. COGS includes the cost of materials used to make that good and the cost of labor to produce it. COGS does not include indirect expenses, like marketing, accounting, and shipping.

Knowing the COGS helps a business to determine accurately which of its products is turning a profit. By subtracting COGS from the sales revenue, a business can determine the gross profit earned on particular goods. Net profit, in the same way, is the difference between COGS and indirect expenses from sales revenue.

COGS and its relationship to profits are perhaps best explained by a specific example. A manufacturer of teddy bears takes in $10,000 in revenue in the month of November. The amount of direct expenses — material and labor costs — for that product in that month was $4,000. Indirect expenses totaled $1,000. Gross profit, then, was $6,000, and net profit was $5,000. What is the COGS in this scenario? It's the direct expenses, $4,000.

Because COGS depends on outside forces, such as the cost of material, it can vary in volatility from month to month and even from day to day. A sudden spike in the cost of oil can certainly send gasoline prices spiraling. The resulting price increase might bring about a decrease in demand and purchase of goods, thereby decreasing the overall profits of the seller of gasoline. In the same way, such a price increase would cut the COGS, since the amount of goods sold would be less. If both profits and costs go down, it's not necessarily a loss for a business, unless the revenue decrease greatly outstrips the drops in costs.

In the same way, a company that sees an increase in both revenues and COGS might not necessarily have a giant profit on its hands. Ideally, however, a company should increase its profits while maintaining or reducing its cost of goods sold. This is the path to true financial well-being.