COGS (Cost of Goods Sold): Definitions, Calculations, and Interpretations

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’s Revenue to calculate Gross Profit.

Cost of Goods Sold (COGS) Definition: 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’s Revenue to calculate Gross Profit.

COGS includes costs directly 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.

If you have information on a company’s Inventory, a simple formula to calculate COGS is:

COGS = Beginning Inventory + Inventory Purchases – Ending Inventory

However, this formula is most effective when inventory is the bulk of COGS.

If a company offers services or its COGS includes a high “labor cost” component, this formula will be less accurate, as you’ll need to factor in these other expenses.

COGS influences key financial indicators ranging from pricing to profit margins and factors into analyses like the breakeven formula directly.

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In most financial modeling exercises, you do not “calculate” COGS – instead, you simply take the company’s historical COGS numbers listed on their Income Statement and forecast them over the projected period. Here’s an example for Illinois Tool Works:

COGS for Illinois Tool Works [ITW]

How to Calculate COGS

If you have very detailed information from a company, you may be able to calculate COGS directly.

The primary components include:

1) Inventory Costs: For companies dealing with physical goods, inventory is a major component of COGS. To calculate inventory-based COGS, the formula is the one above: COGS = Beginning Inventory + Purchases During the Period – Ending Inventory. This gives a measure of the cost of inventory that was sold during one month, one quarter, or one year.

2) Raw Materials: 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.

3) Direct Labor: 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.

Different industries have different COGS structures, and some companies even call their COGS “Cost of Services “or something similar if they are not based on physical products.

For example, a manufacturer such as Illinois Tool Works has COGS or “Cost of Revenue” that consists mostly of inventory costs. You can tell this by reviewing the components of the company’s Inventory:

Inventory Breakout for Illinois Tool Works [ITW]

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 “Cost of Services.”

COGS vs. Operating Expenses

Both COGS and Operating Expenses represent costs, but they differ in their nature and impact on the financial statements.

COGS are the direct costs tied to the production of goods, which are almost always variable in nature.

In other words, as the company produces and sells more products, its COGS should increase in-line with that higher production.

For example, if a company has $100 in revenue and $60 in COGS, and the company’s revenue increases to $120, we would expect its COGS to increase to $72 so that COGS / Revenue remains at 60%.

The company might become slightly more efficient as it scales, so COGS may not be exactly $72, but we would expect something in that range for this type of growth in a short period.

For example, in our operating leverage article that compares a software and services company, the “Variable Costs” would be classified as COGS or Cost of Revenue for both companies:

Operating Leverage Summary

On the other hand, Operating Expenses (OpEx) pertain to the ongoing costs of running a business, independent of the production volume.

These expenses include rent, utilities, marketing, salaries for employees not involved in direct production, and general & administrative costs.

Unlike COGS, many of these expenses remain relatively fixed, regardless of how much the company produces or sells.

As a company’s revenue grows, its OpEx also tends to grow, but unlike COGS, it does not necessarily grow in direct proportion to sales.

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 not necessarily increase to $24.

It might increase to $21 or $22, or it might even remain at $20, depending on the reasons for this increase in sales.

Both COGS and OpEx reduce a company’s Pre-Tax Income and Net Income, but COGS appears “above” Operating Expenses on the Income Statement:

COGS vs. Operating Expenses for Illinois Tool Works [ITW]

How to Interpret COGS

Cost of Goods Sold (COGS) can provide insight into a company’s financial health – specifically, its operational efficiency and profitability.

A lower COGS / Revenue ratio is generally more favorable 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.).

On the flip side, a higher or rising COGS / Revenue ratio over time can cause concern. It indicates that the company’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.

The Gross Margin is the inverse of the COGS / Revenue ratio and is calculated with: (Revenue – COGS) / Revenue.

A declining Gross Margin, resulting from a rising COGS / Revenue ratio, suggests that the company might be facing challenges in managing its direct costs.

These could stem from factors such as rising raw material prices, higher labor costs, or inefficiencies in the production process.

In some cases, it could also point to a lack of pricing power due to a saturated market or competitive pressure.

After all, if a company’s direct production costs are increasing, it could simply raise its prices to offset these expenses.

But if the company cannot do that, it may lack the market or competitive power to raise prices.

Here’s an example for Illinois Tool Works:

COGS / Revenue Ratio for Illinois Tool Work [ITW]

About Brian DeChesare

Brian DeChesare is the Founder of Mergers & Inquisitions and Breaking Into Wall Street. In his spare time, he enjoys lifting weights, running, traveling, obsessively watching TV shows, and defeating Sauron.