Solution Matrix • Cost-Benefit-Analysis

Cost of goods sold (CGS)

Cost of Goods Sold (CGS) is the total cost of acquiring raw materials and turning them into finished goods. CGS normally does not include costs which apply to the whole enterprise, or to selling, general and administrative expenses.

In manufacturing companies, CGS generally has three main components: direct labor, direct materials, and manufacturing overhead. (In companies where the products include service delivery, cost of goods sold may instead be called Cost of Sales or Cost of Services, putting the direct and indirect costs of service delivery in this category instead of manufacturing costs). 

In financial reporting, cost of goods sold is a cost category on the income statement, as shown on the example statement below. Cost of goods sold is subtracted from net sales revenues to produce the reported gross profit. (Gross margin is the gross profit expressed as a percentage of net sales).

The income statement shows reported gross profit for the company, but management usually has a high interest in knowing gross profits for individual product lines and individual products, as well. Such information is crucial for effective product management and product strategy decisions, for instance. For product gross profits, actual sales revenues, actual direct materials, and actual direct labor costs can be estimated rather directly. When manufacturing overhead supports multiple products or product lines, however, the overhead costs for specific products may have to be determined by an arbitrarily set allocation percentage.

Cost of goods sold is further explained and illustrated below in context with other expense categories and the income statement.

Expense Items
Expense Categories and Example Items
Expense Contribution to Gross Profit, Operating Profit, and Net Protit
Expenses: Example Income Statement 

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Expense Items

In simple terms, an expense is usually something a company or organization spends money on (however, exceptions include non-cash expenses, such as depreciation expense or bad debt expense). 

Primary expense categories on the income statement are 

  Cost of goods sold expenses (or Cost of sales expenses).
  Operating expenses (including Selling, general & administrative expenses).
  Financial expenses.
  Extraordinary item expenses.

More formally, an expense is a decrease in owner’s equity caused by the using up of assets in producing revenue or carrying out other activities that are part of the entity’s operations. Every expenditure transaction calls for an impact on an expense category account.  

Expense spending is normally planned, authorized, and managed through budgets developed during the  budget cycle in the organization's budget process. Most expense spending appears either in the organization's Operating budget or the Capital budget, or sub-categories of these (such as the Marketing budget, or the Manufacturing Budget). Some spending of non-budgeted funds may be necessary, however, which may be classified, for instance, as non budgeted spending (or emergency spending, or supplemental funding).

In the language of double entry bookkeeping, transactions with expense category accounts are nearly always debits, which for these accounts means an increase in account balance. Every debit to an expense account will be accompanied by an equal, offsetting credit transaction with a non-expense category account (e.g., asset account, or liability account.  See the encyclopedia entry double entry system for more on offsetting debit and creidt transactions).  

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Expense Categories and Example Items

Expenses and expense category accounts appear under four or five major categories on the income statement: 

  1. Expenses for Cost of goods sold (COGS) (or Cost of  sales).These are the expenses directly associated with producing goods or delivering services.
    Example may include:
      Direct materials expense for manufactured goods
      Purchase of finished goods inventory to be sold.
      Direct labor for manufacturing.
      Manufacturing overhead expense.
       – Indirect labor expense.
       – Depreciation expense of production equipment.
       – Other manufacturing / production / delivery overhead.
  2. Operating Expenses - Selling Expenses. These are the expenses for selling, including such things as:
      Store/shop rental, maintenance expense.
      Sales salaries, commissions.
      Advertising expense.
      Depreciation expense for selling assets 
        (e.g., bar code reading point-of-sale systems).
  3.  Operating Expenses - General & Administrative Expenses. These are essentially expenses for running the company in its normal line of business, which may include such things as:   Executive salaries and other wages and salaries for employees.
        not engaged in manufacturing or selling. 
      Research and development funding.
      Expenses for travel and training.
      IT support expenses (when IT supports the entire organization).
      Depreciation expense for Property, Plant & Equipment assets
       and other assets not solely dedicated to manufacturing or sales.

    [ Note, the two kinds of operating expenses above are sometimes combined in a single category, "Selling, General & Administrative Expenses".] 
  4. Financial Expenses (for companies not in a financial industry)
    These are expenses associated with borrowing funds, or making money from financial investments. These may include
      Loan origination fees
      Interest paid on borrowed funds.
  5. Extraordinary expenses. these are expenses for one time events or transactions, or non recurring actions that are not part of the company's normal business operations. These may include expenses from
      Workforce reduction, laying off employees.
      Sale of land, buildings, or real estate.
      Sale or disposal of other significant assets.
    •  Selling a business. 

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Expense Contribution to Gross Profit, Operating Profit, and Net Profit

Knowing which of the above four high level expense categories a given expense item belongs in is important for at least two reasons:

  • The expense category determines which expense budget includes this item, and
  • The expense category determines which of the several profit calculations on a company's income statement the expense item impacts.

Expenses for Cost of goods sold items (such as direct manufacturing labor, or manufacturing overhead) impact are subtracted from Sales revenues to produce Gross profit and Gross Margin.

Operating Expenses (usually classified as Selling, General, and Administrative Expenses, or divided into two categories, "Selling" and
General and Administrative") are subtracted from Sales revenues—along with Cost of goods sold expenses—to produce operating profit and operating margin.

Extraordinary item expenses and Financial item expenses are normally reported below the operating profit line on the income statement (unless the company is in a financial industry, in which case financial expenses may be part of its normal business).

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Expenses: Example Income Statement

A example of a typical company's income statement showing the expense categories, and how they contribute to different profits, appears here:

 Grande Corporation 
 Income Statement for Year Ending 31 December 2011
      Figures in 1,000s

 Gross sales revenues.................33,329
   Less returns & allowances..........   346
 Net sales revenues...........................32,983
 Cost of goods sold
   Direct materials................... 6,320
   Direct labor....................... 6,100
   Manufacturing overhead
     Indirect labor........... 5,263
     Depreciation, mfr equp...   360
     Other mfr overhead....... 4,000
     Net mfr overhead................. 9,623
     Net cost of goods sold...................22,043

 Gross profit.................................10,940

 Operating expenses
   Selling expenses
     Sales salaries........... 4,200
     Warranty expenses........   730
     Depreciation, store equip   120
     Other selling expenses...   972
     Total selling expenses........... 6,022   
   General & admin expenses
     Administration salaries.. 1,229
     Rent expenses............   180
     Depreciation, computers..   179
     Other gen'l & admin exp..   200
     Total gen'l & admin exp.......... 1,788
       Total operating expenses..............  7,810

 Operating income before taxes...............  3,130

 Financial revenue & expenses
   Revenue from investments............  118
   Less interest expense...............  511
     Net financial gain (expense)............  (393)

 Income before tax & extraordinary items.....  2,737
   Less income tax on operations.............    958
 Income before extraordinary items...........  1,779

 Extraordinary items
   Sale of land.................  610
   Less initial cost............  145
     Net gain on sale of land..........  465
   Less income tax on gain ............  118
     Extraordinary items after tax............   347

 Net Income (Profit).......................... 2,126
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