Cost Of Goods Sold, or COGS.
This video explains Cost Of Goods Sold in an easy to understand way.
We will start off with some examples of Cost Of Goods Sold from the real world, discuss
how COGS relates to gross profit and inventory, review the COGS formula, and calculate Cost
Of Goods Sold using both the FIFO and the LIFO methods.
Let’s warm up with a short quiz question.
Which of the following companies does not have Cost Of Goods Sold in its income statement?
Apple? Facebook?
Johnson and Johnson? Or Walmart?
Please vote now, and then let’s review how Cost Of Goods Sold works for those companies
that have it.
Apple’s income statement.
Net sales of $260 billion at the top, net income of $55 billion at the bottom.
Within Cost Of Sales, there are two line items:
cost of sales of products, and cost of sales of services.
Cost of sales of products is what we are looking for,
this is the same thing as Cost Of Goods Sold.
Basically, COGS for Apple is the cost of manufacturing (labor, materials, and overhead) for the iPhones,
Macs, iPads and whatever other physical products that Apple sold during the year, plus their
estimated warranty costs.
For all the products whose revenue is in net sales of products, the costs should be in
cost of sales of products.
Facebook’s income statement [for Q4 of 2019].
Net sales of $21 billion at the top [FOR ONE QUARTER - NOT FULL YEAR!],
net income of $7 billion [FOR ONE QUARTER - NOT FULL YEAR!] at the bottom.
This is the company that does not have Cost Of Goods Sold in its income statement.
Facebook’s revenue is driven by advertising, and its cost of revenue is in running its
virtual platforms.
Johnson & Johnson’s income statement.
Net sales of $82 billion at the top, net income of $15 billion at the bottom.
Cost of products sold is right below the revenue line.
Sales to customers minus cost of products sold is gross profit.
For all the products whose revenue is in sales to customers,
the costs should be in cost of products sold.
Walmart’s income statement.
Net sales of $510 billion at the top, net income of $7 billion at the bottom.
Cost of sales, more specifically Cost Of Goods Sold, is the actual product cost plus transportation
plus some of the warehousing costs.
According to Walmart’s annual report, the majority of the cost of warehousing and occupancy
for distribution facilities is included in
operating, selling, general and administrative expenses, not in COGS.
So the answer to the question which of the companies does not have Cost Of Goods Sold
in its income statement is Facebook, as this company does not sell physical goods.
How does Cost Of Goods Sold relate to Gross Profit?
Let’s say you are full of ideas, you like to invent stuff.
You have come up with a breakthrough product, and got a prototype working.
However, your personal strength is really in inventing,
not in manufacturing, nor in selling.
So you get somebody else to do the manufacturing of your product for you.
They produce the goods according to your specifications,
ship them to you, and you pay cash on delivery.
You also get somebody else for the selling of the product to consumers.
You ship the goods to a retailer, but instead of the retailer paying you immediately, you
will receive payment after thirty days.
This month, you buy 100 units at $80 each, and sell 50 units at $100 each.
How much profit or loss do you make?
Voting time again!
For this accounting period, are you making a loss of $8000, a loss of $3000,
a profit of $1000, or a profit of $5000?
What do you think?
If you need a bit more time to think about it, please pause the video and then vote.
Once you have voted, let’s go through the calculation.
You deliver and sell 50 units at $100 each, so your revenue is $5000.
The cost to you of sourcing those 50 units that you have now sold, is 50 units at $80
each, so your Cost Of Goods Sold is $4000.
In short, you sell 50 units at $20 margin per unit, so generate a profit of $1000.
But wait, didn’t you buy 100 units and only sell 50?
Yes! Those 50 units that haven’t been sold yet stay in inventory, at a value of $4000.
To clarify this, let’s go through the journal entries for the transactions.
These will involve three balance accounts: cash, inventory and accounts receivable.
And two income statement accounts: Cost Of Goods Sold, and revenue.
The first journal entry covers the purchase of goods from the supplier, paid in cash:
debit inventory for $8000, credit cash for $8000.
Invoicing the customer: debit accounts receivable for $5000, credit revenue for $5000.
Delivering the product to the customer (an integral part of the sales transaction):
debit cost of goods sold for $4000, credit inventory for $4000.
Gross profit is $1000: revenue of $5000 minus cost of goods sold of $4000.
The ending inventory balance is $4000: purchases of $8000 (100 units) minus the 50 units that
were sold to the customer at a cost of goods sold value of $4000.
Another way to look at the same numbers is to use the Cost Of Goods Sold formula.
Beginning inventory, in this case zero, plus purchases of $8000, minus ending inventory
of $4000, equals cost of goods sold of $4000.
Important variables here are the value of the beginning inventory and the ending inventory.
Bonus topic, with a new example!
Let’s calculate Cost Of Goods Sold using both the FIFO and the LIFO methods.
The acronym FIFO stands for First In First Out.
The acronym LIFO stands for Last In First Out.
Both FIFO and LIFO are cost accounting fictions that can lead to very different numbers of
Cost Of Goods Sold and Gross Profit.
In the first quarter of the year, Toy Giraffe Inc is building up its inventory.
In January, they buy 100 units at $5 per unit.
In February, 200 units at $6 per unit.
In March, another 100 units at $7 per unit.
The Q1 ending inventory for both FIFO and LIFO is 400 units at a total purchase price
of $2400, so on average $6 per unit.
For inventory valuation as well as determining Cost Of Goods Sold, it is important to determine
what is the cost per unit for the 50 units sold in April.
With FIFO, First In First Out, we assume that the oldest inventory gets sold first, so we
assume that the box of units sold originated from the January buy.
What remains in inventory at the end of April is 50 units from the January buy, the full
200 units from the February buy, and the full 100 units from the March buy.
In total, 350 units with a total purchase price of $2150, so on average $6.14 per unit,
an increase of the weighted average unit cost up from $6 previously.
If we prepare the income statement for April, revenue is 50 units times $10 = $500, Cost
Of Goods Sold (or COGS) is 50 units times $5 = $250, and Gross Profit is $250.
Out of the January buy that was part of the beginning inventory, 50 units go to COGS,
and 50 units go to the ending inventory.
With LIFO, Last In First Out, we assume that the newest inventory gets sold first, so we
assume that the box sold originated from the March buy.
What remains in inventory at the end of April is the full 100 units from the January buy,
the full 200 units from the February buy, and the remaining 50 units from the March buy.
In total, 350 units with a total purchase price of $2050, so on average $5.86 per unit.
Under LIFO, the average cost per unit in inventory goes down in this example, compared to the
$6 previously.
If we prepare the income statement for April, revenue is 50 units times $10 = $500, Cost
Of Goods Sold (or COGS) is 50 units times $7 = $350, and Gross Profit is $150.
Out of the March buy that was part of the beginning inventory, 50 units go to COGS,
and 50 units go to the ending inventory.
We can put the Cost Of Goods Sold formula side by side for FIFO and LIFO.
Beginning inventory of $2400, plus purchases of zero, minus FIFO ending inventory of $2150,
equals Cost of Goods Sold of $250.
Beginning inventory of $2400, plus purchases of zero, minus LIFO ending inventory of $2050,
equals Cost of Goods Sold of $350.
The higher the ending inventory value, the lower the Cost Of Goods Sold.
The lower the Cost Of Goods Sold, the higher the (taxable) profit.
The lower the ending inventory value, the higher the Cost Of Goods Sold.
The higher the Cost Of Goods Sold, the lower the (taxable) profit.
Cost Of Goods Sold, Gross Profit, and inventory.
Remember to always take the same number of units into COGS as the number of units you
have in revenue.
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