{"id":27230,"date":"2024-01-10T20:00:52","date_gmt":"2024-01-11T01:00:52","guid":{"rendered":"https:\/\/breakingintowallstreet.com\/?post_type=biws_kb&#038;p=27230"},"modified":"2024-08-01T19:11:33","modified_gmt":"2024-08-02T00:11:33","slug":"cogs","status":"publish","type":"biws_kb","link":"https:\/\/breakingintowallstreet.com\/kb\/accounting\/cogs\/","title":{"rendered":"COGS (Cost of Goods Sold): Definitions, Calculations, and Interpretations"},"content":{"rendered":"<div id=\"ez-toc-container\" class=\"ez-toc-v2_0_81 counter-flat ez-toc-counter ez-toc-grey ez-toc-container-direction\">\n<div class=\"ez-toc-title-container\">\n<p class=\"ez-toc-title\" style=\"cursor:inherit\">COGS (Cost of Goods Sold): Definitions, Calculations, and Interpretations<\/p>\n<span class=\"ez-toc-title-toggle\"><\/span><\/div>\n<nav><ul class='ez-toc-list ez-toc-list-level-1 ' ><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-1\" href=\"https:\/\/breakingintowallstreet.com\/kb\/accounting\/cogs\/#COGS_Cost_of_Goods_Sold_Definitions_Calculations_and_Interpretations\">COGS (Cost of Goods Sold): Definitions, Calculations, and Interpretations<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-2\" href=\"https:\/\/breakingintowallstreet.com\/kb\/accounting\/cogs\/#How_to_Calculate_COGS\">How to Calculate COGS<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-3\" href=\"https:\/\/breakingintowallstreet.com\/kb\/accounting\/cogs\/#COGS_vs_Operating_Expenses\">COGS vs. Operating Expenses<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-4\" href=\"https:\/\/breakingintowallstreet.com\/kb\/accounting\/cogs\/#How_to_Interpret_COGS\">How to Interpret COGS<\/a><\/li><\/ul><\/nav><\/div>\n\n<h2><span class=\"ez-toc-section\" id=\"COGS_Cost_of_Goods_Sold_Definitions_Calculations_and_Interpretations\"><\/span>COGS (Cost of Goods Sold): Definitions, Calculations, and Interpretations<span class=\"ez-toc-section-end\"><\/span><\/h2>\n<blockquote><p><strong>Cost of Goods Sold (COGS) Definition:<\/strong> COGS are the direct costs attributable to the production of goods sold by a company. This amount includes the cost of the materials used to create the good and the direct labor costs used to produce the good. COGS is subtracted from a company&#8217;s Revenue to calculate Gross Profit.<\/p><\/blockquote>\n<p>COGS includes costs <strong>directly<\/strong> tied to production, such as raw materials and the direct labor involved in the manufacturing process. Overheads and indirect costs like rent, utilities, and employee salaries for non-production tasks are not included.<\/p>\n<p>If you have information on a company\u2019s Inventory, a simple formula to calculate COGS is:<\/p>\n<p><strong>COGS<\/strong> = Beginning Inventory + Inventory Purchases \u2013 Ending Inventory<\/p>\n<p>However, this formula is most effective when <strong>inventory<\/strong> is the bulk of COGS.<\/p>\n<p>If a company offers services or its COGS includes a high \u201clabor cost\u201d component, this formula will be less accurate, as you\u2019ll need to factor in these other expenses.<\/p>\n<p>COGS influences key financial indicators ranging from pricing to profit margins and factors into analyses like the <a href=\"https:\/\/breakingintowallstreet.com\/kb\/accounting\/breakeven-formula\/\" target=\"_blank\" rel=\"noopener\">breakeven formula<\/a> directly.<\/p>\n<div class='code-block code-block-2' style='margin: 8px 0; clear: both;'>\n<div class=\"kb-adinsert-modal\">\n    <div class=\"kb-adinsert-top\">\n      <div class=\"media\">\n          <img decoding=\"async\" class=\"alignnone size-full wp-image-28448\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/04\/24164120\/adv-fm-tile.png\" alt=\"PowerPoint Pro\" width=\"128\" height=\"128\" \/>\n      <\/div>\n      <div class=\"content\">\n          <h3>Master Financial Modeling for Investment Banking With <strong>BIWS Core Financial Modeling<\/strong><\/h3>\n      <\/div>\n    <\/div>\n    \n    <div class=\"full_text\">\n    \t<ul>\n        \t<li>\n            \t<h4>Become a financial modeling pro<\/h4>\n              <p>158 videos, detailed written guides, Excel files, quizzes, and more<\/p>\n\t\t\t    <\/li>\n          <li>\n          \t<h4>Complete 10+ detailed global case studies<\/h4>\n            <p>These include both the theory and the practical applications<\/p>\n\t\t\t    <\/li>\n          <li>\n          \t<h4>Prepare for your internship or full-time job<\/h4>\n            <p>Gain the skills you need to \u201chit the ground running\u201d on Day 1\n\n<\/p>\n\t\t\t  <\/li>\n      <\/ul>\n        \n      <a class=\"cta-link orange-button-medium\" href=\"https:\/\/breakingintowallstreet.com\/core-financial-modeling\/\" target=\"_blank\">Full Details<\/a>\n      \n      <a class=\"cta-link orange-button-medium bg-blue\" href=\"https:\/\/biws-support.s3.us-east-1.amazonaws.com\/Course-Outlines\/Core-Financial-Modeling-Course-Outline.pdf\" target=\"_blank\" rel=\"noopener\">Short Outline<\/a>\n    <\/div>\n<\/div><\/div>\n\n<p>In most <a href=\"https:\/\/mergersandinquisitions.com\/financial-modeling\/\" target=\"_blank\" rel=\"noopener\">financial modeling<\/a> exercises, you do not &#8220;calculate&#8221; COGS &#8211; instead, you simply take the company&#8217;s historical COGS numbers listed on their Income Statement and forecast them over the projected period. Here&#8217;s an example for Illinois Tool Works:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-27231 size-full\" title=\"COGS for Illinois Tool Works [ITW]\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/01\/10195753\/01-COGS-ITW.jpg\" alt=\"COGS for Illinois Tool Works [ITW]\" width=\"1664\" height=\"528\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/01\/10195753\/01-COGS-ITW.jpg 1664w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/01\/10195753\/01-COGS-ITW-300x95.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/01\/10195753\/01-COGS-ITW-1024x325.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/01\/10195753\/01-COGS-ITW-768x244.jpg 768w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/01\/10195753\/01-COGS-ITW-1536x487.jpg 1536w\" sizes=\"(max-width: 1664px) 100vw, 1664px\" \/><\/p>\n<h2><span class=\"ez-toc-section\" id=\"How_to_Calculate_COGS\"><\/span>How to Calculate COGS<span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>If you have very detailed information from a company, you may be able to calculate COGS directly.<\/p>\n<p>The primary components include:<\/p>\n<p><strong>1) Inventory Costs:<\/strong> For companies dealing with physical goods, inventory is a major component of COGS. To calculate inventory-based COGS, the formula is the one above: <strong>COGS<\/strong> = Beginning Inventory + Purchases During the Period \u2013 Ending Inventory. This gives a measure of the cost of inventory that was sold during one month, one quarter, or one year.<\/p>\n<p><strong>2) Raw Materials:<\/strong> This relates to the primary materials that are transformed into the final product. For a manufacturer, this might mean the cost of steel to produce machinery; for a baker, it might refer to the cost of flour to bake bread.<\/p>\n<p><strong>3) Direct Labor:<\/strong> This is the cost of labor directly involved in producing a finished good or delivering a service. For a factory, this includes the salaries of the workers on the production line; for a software firm, it might include costs related to customer support, servers, bandwidth, and so on.<\/p>\n<p>Different industries have different COGS structures, and some companies even call their COGS &#8220;Cost of Services &#8220;or something similar if they are not based on physical products.<\/p>\n<p>For example, a manufacturer such as Illinois Tool Works has COGS or &#8220;Cost of Revenue&#8221; that consists mostly of inventory costs. You can tell this by reviewing the components of the company&#8217;s Inventory:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-27232 size-full\" title=\"Inventory Breakout for Illinois Tool Works [ITW]\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/01\/10195819\/02-ITW-Inventory.jpg\" alt=\"Inventory Breakout for Illinois Tool Works [ITW]\" width=\"1676\" height=\"232\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/01\/10195819\/02-ITW-Inventory.jpg 1676w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/01\/10195819\/02-ITW-Inventory-300x42.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/01\/10195819\/02-ITW-Inventory-1024x142.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/01\/10195819\/02-ITW-Inventory-768x106.jpg 768w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/01\/10195819\/02-ITW-Inventory-1536x213.jpg 1536w\" sizes=\"(max-width: 1676px) 100vw, 1676px\" \/><\/p>\n<p>By contrast, a Software-as-a-Service (SaaS) company might consider expenses like customer support, payment processing fees, and server infrastructure as the primary components of COGS and label it \u201cCost of Services.\u201d<\/p>\n<h2><span class=\"ez-toc-section\" id=\"COGS_vs_Operating_Expenses\"><\/span>COGS vs. Operating Expenses<span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>Both COGS and Operating Expenses represent costs, but they differ in their nature and impact on the financial statements.<\/p>\n<p><strong>COGS are the direct costs tied to the production of goods, which are almost always\u00a0<em>variable<\/em> in nature.<\/strong><\/p>\n<p>In other words, as the company <em>produces and sells more products<\/em>, its COGS should <strong>increase<\/strong> in-line with that higher production.<\/p>\n<p>For example, if a company has $100 in revenue and $60 in COGS, and the company\u2019s revenue increases to $120, we would expect its COGS to increase to $72 so that COGS \/ Revenue remains at 60%.<\/p>\n<p>The company might become slightly more efficient as it scales, so COGS may not be exactly $72, but we would expect something in <em>that range<\/em> for this type of growth in a short period.<\/p>\n<p>For example, in our <a href=\"https:\/\/breakingintowallstreet.com\/kb\/financial-statement-analysis\/operating-leverage\/\" target=\"_blank\" rel=\"noopener\">operating leverage article<\/a> that compares a software and services company, the &#8220;Variable Costs&#8221; would be classified as\u00a0<strong>COGS or Cost of Revenue<\/strong> for both companies:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-27152 size-full\" title=\"Operating Leverage Summary\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/11\/27204215\/01-Operating-Leverage-Summary.jpg\" alt=\"Operating Leverage Summary\" width=\"1103\" height=\"592\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/11\/27204215\/01-Operating-Leverage-Summary.jpg 1103w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/11\/27204215\/01-Operating-Leverage-Summary-300x161.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/11\/27204215\/01-Operating-Leverage-Summary-1024x550.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/11\/27204215\/01-Operating-Leverage-Summary-768x412.jpg 768w\" sizes=\"(max-width: 1103px) 100vw, 1103px\" \/><\/p>\n<p>On the other hand, <strong>Operating Expenses (OpEx) pertain to the ongoing costs of running a business, independent of the production volume<\/strong>.<\/p>\n<p>These expenses include rent, utilities, marketing, salaries for employees <em>not<\/em> involved in direct production, and general &amp; administrative costs.<\/p>\n<p>Unlike COGS, many of these expenses remain relatively fixed, regardless of how much the company produces or sells.<\/p>\n<p>As a company\u2019s revenue grows, its OpEx also tends to grow, but unlike COGS, it does <em>not<\/em> necessarily grow in direct proportion to sales.<\/p>\n<p>For example, if the company has $100 in revenue, $60 in COGS, and $20 in OpEx, and its revenue increases to $120 (following the example above), OpEx would <strong>not<\/strong> necessarily increase to $24.<\/p>\n<p>It might increase to $21 or $22, or it might even remain at $20, depending on the reasons for this increase in sales.<\/p>\n<p>Both COGS and OpEx reduce a company&#8217;s Pre-Tax Income and <a href=\"https:\/\/breakingintowallstreet.com\/kb\/accounting\/net-income\/\" target=\"_blank\" rel=\"noopener\">Net Income<\/a>, but COGS appears &#8220;above&#8221; Operating Expenses on the Income Statement:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-27233 size-full\" title=\"COGS vs. Operating Expenses for Illinois Tool Works [ITW]\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/01\/10195936\/04-ITW-COGS-vs-OpEx.jpg\" alt=\"COGS vs. Operating Expenses for Illinois Tool Works [ITW]\" width=\"1664\" height=\"585\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/01\/10195936\/04-ITW-COGS-vs-OpEx.jpg 1664w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/01\/10195936\/04-ITW-COGS-vs-OpEx-300x105.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/01\/10195936\/04-ITW-COGS-vs-OpEx-1024x360.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/01\/10195936\/04-ITW-COGS-vs-OpEx-768x270.jpg 768w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/01\/10195936\/04-ITW-COGS-vs-OpEx-1536x540.jpg 1536w\" sizes=\"(max-width: 1664px) 100vw, 1664px\" \/><\/p>\n<h2><span class=\"ez-toc-section\" id=\"How_to_Interpret_COGS\"><\/span>How to Interpret COGS<span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>Cost of Goods Sold (COGS) can provide insight into a company&#8217;s financial health \u2013 specifically, its operational efficiency and profitability.<\/p>\n<p><strong>A lower COGS \/ Revenue ratio is generally more favorable<\/strong> because it means the company can afford to spend more on the rest of its business, including expansion efforts (e.g., opening new stores, building more factories, hiring more employees, etc.).<\/p>\n<p>On the flip side, <strong>a higher or rising COGS \/ Revenue ratio<\/strong> over time can cause concern. It indicates that the company&#8217;s production costs are rising faster than its sales, which can squeeze profit margins and limit the capital available for other operational needs or growth initiatives.<\/p>\n<p>The <a href=\"https:\/\/breakingintowallstreet.com\/kb\/accounting\/gross-margin\/\" target=\"_blank\" rel=\"noopener\">Gross Margin<\/a> is the inverse of the COGS \/ Revenue ratio and is calculated with: (Revenue \u2013 COGS) \/ Revenue.<\/p>\n<p>A declining Gross Margin, resulting from a rising COGS \/ Revenue ratio, suggests that the company might be facing challenges in managing its direct costs.<\/p>\n<p>These could stem from factors such as rising raw material prices, higher labor costs, or inefficiencies in the production process.<\/p>\n<p>In some cases, it could also point to <strong>a lack of pricing power<\/strong> due to a saturated market or competitive pressure.<\/p>\n<p>After all, if a company\u2019s direct production costs are increasing, it could simply raise its prices to offset these expenses.<\/p>\n<p>But if the company <strong>cannot<\/strong> do that, it may lack the market or competitive power to raise prices.<\/p>\n<p>Here&#8217;s an example for Illinois Tool Works:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-27234 size-full\" title=\"COGS \/ Revenue Ratio for Illinois Tool Work [ITW]\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/01\/10200005\/05-ITW-COGS-Revenue.jpg\" alt=\"COGS \/ Revenue Ratio for Illinois Tool Work [ITW]\" width=\"1664\" height=\"545\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/01\/10200005\/05-ITW-COGS-Revenue.jpg 1664w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/01\/10200005\/05-ITW-COGS-Revenue-300x98.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/01\/10200005\/05-ITW-COGS-Revenue-1024x335.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/01\/10200005\/05-ITW-COGS-Revenue-768x252.jpg 768w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/01\/10200005\/05-ITW-COGS-Revenue-1536x503.jpg 1536w\" sizes=\"(max-width: 1664px) 100vw, 1664px\" \/><\/p>\n","protected":false},"excerpt":{"rendered":"<p>COGS are the direct costs attributable to the production of goods sold by a company. This amount includes the cost of the materials used to create the good and the direct labor costs used to produce the good. COGS is subtracted from a company&#8217;s Revenue to calculate Gross Profit.<\/p>\n","protected":false},"featured_media":29313,"template":"","class_list":["post-27230","biws_kb","type-biws_kb","status-publish","has-post-thumbnail","hentry","kb_category-accounting"],"acf":[],"_links":{"self":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/biws_kb\/27230","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/biws_kb"}],"about":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/types\/biws_kb"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/media\/29313"}],"wp:attachment":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/media?parent=27230"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}