What is Cost of Goods Sold (COGS)?

The cost of goods sold or COGS refers to direct costs that lead to the creation of a good or product that a company sells. Direct costs include the financial means it takes to manufacture the product, raw material and labor costs. The simplest COGS definition is the combination of costs required to produce a good. Indirect costs, such as distribution, are left out of the cost of goods sold.

The basic COGS formula-

Cost of Good Sold = (Initial Inventory + Additional Costs) - Ending Inventory

To calculate COGS, add to the cost of the initial inventory, additional material plus labor costs. From that, the value of inventory to be sold is deducted.

The Significance of COGS- Impact on Financial Statements

COGS is critical for analyzing a firm's financial position and prospects of making profits. This is a look at its impact on the various financial statements.

Income statement- COGS is a line item on the income statement, which directly affects the computation of gross profit. Gross profit is the difference between revenue (sales) and COGS. When gross revenue is subtracted from sales, the balance of COGS shows gross profit, which can reflect the level of profitability, either high or low.

Balance sheet: COGS indirectly impacts the balance sheet through its effect on ending inventory. First-In-First-Out (FIFO), Last-In-First-Out (LIFO), or average cost method is the inventory valuation method that influences the COGS calculation and, thereby, the profit reported.