Cost of Goods Sold, (COGS), can also be referred to as cost of sales (COS), cost of revenue, or product cost, depending on if it is a product or service. It includes all the costs directly involved in producing a product or delivering a service. These costs can include labor, material, and shipping. The idea behind COGS is to measure all costs (which are variable) directly associated with making the product or delivering the service.
Let’s assume you start a delivery company and line up a few customers. In the first full month of operation you do $10,000 worth of business (this becomes our revenue line). For that month we also had expenses, including the cost of gas for the delivery truck in the amount of $2,000, and the salary of the driver at $3,000. These costs are directly related to our service and fall into the Cost of Goods Sold (COGS) line. There are more line items that would be included in COGS, but you get the idea. All other expenses not directly related to the product or service goes under a category called Operating Expenses such as your receptionists’ or accountants’ salary. The top part of our income statement (with our COGS line) would look like this:
(Excerpts from Financial Intelligence, Chapter 8 – Costs and Expenses)
If you suspect that rule [what goes into COGS/COS] is open to a ton of interpretation, you’re on the money. The accounting department has to make decisions about what to include in COGS or COS and what to put somewhere else.
Some of these decisions are easy. In a manufacturing company, for instance, the following costs are definitely in:
- The wages of the people on the manufacturing line
- The cost of the materials that are used to make the product\
And plenty of costs are definitely out, such as:
- The cost of supplies used by the accounting department (paper, etc.)
- The salary of the human resources manager in the corporate office
Ah, but then there’s the gray area—and it’s enormous. For example:
- What about the salary of the person who manages the plant where the product is manufactured?
- What about the wages of the plant supervisor?
- What about sales commissions?
Are all of these directly related to the manufacturing of the product? Or are they operating expenses, like the cost of the HR manager? There’s the same ambiguity in the service environment. COS in a service company typically includes labor associated with delivering the service. But what about…