Cost of goods sold (COGS) is the direct cost of producing the goods that a company sells. It includes the cost of materials, labor, and overhead. COGS is an important metric for measuring a company’s profitability, as it is subtracted from revenue to calculate gross profit.
There are two main methods for calculating COGS:
- First-in, first-out (FIFO): FIFO assumes that the first goods that were purchased are the first goods that are sold. This means that the cost of goods sold will be based on the cost of the oldest inventory.
- Last-in, first-out (LIFO): LIFO assumes that the last goods that were purchased are the first goods that are sold. This means that the cost of goods sold will be based on the cost of the newest inventory.
The method that a company uses to calculate COGS will affect its gross profit and net income. For example, a company that uses FIFO will have a higher gross profit and net income than a company that uses LIFO, if the cost of goods has increased over time.
Here are some of the factors that can affect a company’s COGS:
- The cost of materials: The cost of materials is the most significant component of COGS. It includes the cost of raw materials, such as the cost of cotton for a clothing company, and the cost of packaging materials.
- The cost of labor: The cost of labor is another significant component of COGS. It includes the cost of direct labor, such as the cost of the wages paid to factory workers, and the cost of indirect labor, such as the cost of the wages paid to factory supervisors.
- Overhead: Overhead is the cost of all other expenses incurred in the production of goods, such as the cost of rent, utilities, and insurance.
Companies can manage their COGS by:
- Negotiating better prices with suppliers: Companies can negotiate better prices with suppliers by increasing their bargaining power. This can be done by increasing the volume of purchases, by diversifying the supplier base, or by threatening to switch suppliers.
- Improving efficiency: Companies can improve efficiency by reducing waste and by streamlining production processes. This can lead to lower costs and higher profits.
- Using technology: Companies can use technology to improve efficiency and to reduce costs. For example, companies can use robots to automate tasks or they can use software to track inventory and to optimize production schedules.
By managing their COGS, companies can improve their profitability and their competitive position.