Cost of Goods Sold: Only for Inventory-Based Businesses

Cost of Goods Sold (COGS) is an important accounting concept for businesses that sell physical goods. It represents the direct costs associated with producing or acquiring the goods that were sold during a given period. COGS is deducted from revenue to calculate gross profit, which is a key measure of profitability.

What is COGS?

COGS (Income Statement line item) comes from Inventory-on-hand (Balance Sheet line item) and typically it simply is the wholesale cost of the merchandise or inventory that was sold to customers. Taking a deeper look, you can also say that COGS includes the following costs:

• Direct materials: The cost of raw materials that are directly used in the production of goods.

• Direct labor: The cost of labor that is directly associated with the production of goods.

• Overhead costs: Certain indirect costs associated with the production of goods, such as factory rent and utilities.

Why COGS is important for inventory-based businesses

COGS is important for inventory-based businesses because it helps them to accurately measure their profitability. When COGS is deducted from revenue, the result is gross profit. Gross profit represents the amount of money that a business has left over after covering the direct costs of producing or acquiring the goods that it sold.

Gross profit is an important measure of profitability because it shows how much money a business is making on its core business activities. By tracking gross profit over time, businesses can identify trends and make adjustments to their operations as needed.

Why COGS should not be used for service-based businesses

Service-based businesses do not have physical inventory, so they do not have COGS. Service-based businesses typically incur costs such as labor, rent, and utilities, but these costs are considered to be operating expenses. Operating expenses are deducted from revenue to calculate net income, which is the bottom line of the income statement.

Here are some examples of businesses that should use COGS:

• Retailers

• Manufacturers

• Wholesalers

• Restaurants

• Auto dealership

Here are some examples of businesses that should not use COGS:

• Accounting firms

• Law firms

• Consulting firms

• Software companies

• Graphic design firms

Conclusion

COGS is an important accounting concept for inventory-based businesses. It helps businesses to accurately measure their profitability and identify trends in their operations. Service-based businesses do not have physical inventory, so they do not have COGS.

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