Cost of Goods Sold (COGS) on the Income Statement

Investing Lesson 4 - Analyzing an Income Statement

Understanding the Cost of Goods Sold or COGS on the Income Statement

The next section of the income statement we need to study in your quest to learn about income statement analysis is the cost of goods sold, or COGS for short.

Cost of goods sold represents the expenses a company has paid in order to manufacture, source, and deliver a product or service to the end customer. This includes everything from the purchase price of the raw material to the expenses of transforming it into a product, the packaging that surrounds it, to the freight charges paid to have it delivered to store shelves. It also includes the cost of paying the workers who make the product. In some circles. the cost of goods sold is also known as cost of revenue or cost of sales.

Going back to our pizza parlor example from earlier in this investing lesson, your cost of goods sold would include the amount of money you spent purchasing items such as flour and tomato sauce, the box you used to keep the pizza safe during delivery, and the amount of money you paid your restaurant vendor for individual packets of parmesan cheese. It would include the money you pay to the soft drink company to refill the syrup in the soda fountains.

The cost of goods sold per dollar of sales will differ depending upon the type of business you own or in which you buy shares of stock. A licensing company, advertising group, or law firm will have virtually no cost of goods sold compared to a typical manufacturing enterprise because they are selling a service and not a tangible product. Instead, most of their costs are going to show up under a different section of the income statement we will discuss later called Selling, General, and Administrative expenses, or SG&A expenses.

Calculating COGS and the Impact on Profits

There's a relatively simple way to determine the cost of goods sold by comparing inventory at the start of a period and the end.

The formula is:

COGS = Beginning Inventory + Purchases during the period – Ending Inventory.

Cost of goods sold is an important figure for investors to look at because it has a direct impact on profits. Cost of goods sold is deducted from revenues when determining a company's gross profit. Gross profit, in turn, is a measure of how efficient a company is at managing its operations. Thus, if the cost of goods sold is too high, profits suffer and investors worry about how well the company is doing overall.

Comparing COGS

Before you invest in a business, you'll want to research the industry you are examining and find out what is considered a normal, or good, cost of goods sold ratio relative to sales. For corporations that drill for oil, one of the most important figures you need to consider is the cost per barrel to get the oil out of the ground, refined, and sold. This is, in effect, the cost of goods sold for the oil company. If one firm can get crude at far lower costs than its competitors, it has a distinct advantage and will result in more profit flowing to the owners or shareholders, especially during periods when oil prices collapse.

 This is one of the reasons that major oil companies such as ExxonMobil are able to buy up assets of struggling and bankrupt competitors during energy gluts.

Another thing you want to try and figure out is the degree to which a firm is exposed to a particular input cost. For Southwest Airlines, the cost of jet fuel--and thus, oil and refining--is the most important cost the company has. For Starbucks, it's coffee. For Coca-Cola, sugar and corn prices are extremely important. One of the reasons some investors are extremely successful is because they know the exact relationship between profits and cost of goods sold. It's been noted that Warren Buffett knows the profitability figures for a single can of Coca-Cola and watches sugar prices regularly.

As an investor, you need to be aware of the risk a business faces due to ​the unexpected higher cost of goods sold regardless of if you are buying shares of stock, purchasing a local business, or launching your own start-up.