What is COGS (Cost of Goods Sold)?

Cost of Goods Sold (COGS), also known as cost of sales, is the total direct expenses incurred in the production of a good, including the cost of materials used to make that good and the cost of labor to produce it. It does not include indirect expenses, like marketing, accounting, and shipping.

It's important for a business to know the COGS of its products, since this helps it determine accurately which products is turning a profit. By subtracting the 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.

The way these costs relate to profit can be seen in the following example. For instance, 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. The COGS in this scenario is the direct expenses, $4,000.

Because COGS depends on outside forces, such as the cost of material, it can vary from month to month and even from day to day. A sudden spike in the cost of oil can send gasoline prices soaring. 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.

Written by David White