Cost of goods sold (COGS) on an income statement represents the expenses a company has paid to manufacture, source, and ship a product or service to the end customer.
What Goes Into Cost of Goods Sold
COGS includes everything from the purchase price of the raw material to the expenses of transforming it into a product and packaging 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.
If you own a pizza parlor, your cost of goods sold would include the amount of money you spend purchasing such items as flour, tomato sauce, and the box you use to keep the pizza safe during delivery. It would also include the payment to your restaurant vendor for individual packets of Parmesan cheese as well as the payment to the soft drink company to refill the syrup in the soda fountains.
A relatively simple way to determine the cost of goods sold is to compare inventory at the start and end of a given period using the formula: COGS = Beginning Inventory + Additional Inventory - Ending Inventory.
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. A licensing company, advertising group, or law firm will have virtually no cost of goods sold compared to a typical manufacturing enterprise since they are selling a service and not a tangible product. Instead, most of their costs will show up under a different section of the income statement called selling, general and administrative expenses (SG&A).
Calculating COGS and the Impact on Profits
Cost of goods sold is an important figure for investors to consider because it has a direct impact on profits. Cost of goods sold is deducted from revenue to determine 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 naturally worry about how well the company is doing overall.
Comparing COGS to Sales Ratios
Before you invest in a business, research the industry the business operates in and find out what is considered a normal, or good, COGS ratio relative to sales. For oil drilling companies, 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 company.
If one company can get crude oil 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 reason major oil companies such as ExxonMobil are able to buy up assets of struggling and bankrupt competitors during energy gluts.
You may also want to figure out the degree to which a company 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 is coffee beans. For Coca-Cola, sugar and corn prices are extremely important.
Some investors are extremely successful precisely because they know the exact relationship between profits and cost of goods sold. For instance, it has been noted that investor 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 whether you are buying shares, purchasing a local business, or launching your own startup.