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
[ Page Top ] [ Encyclopedia ] [ Business Case Books & Tools ] [ Home ]
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).
[ Page Top ] [ Encyclopedia ] [ Business Case Books & Tools ] [ Home ]
Expense Categories and Example Items
Expenses and expense category accounts appear under four or five major categories on the income statement:
- 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. - 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). - 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".] - 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. - 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.
[ Page Top ] [ Encyclopedia ] [ Business Case Books & Tools ] [ Home ]
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).
[ Page Top ] [ Encyclopedia ] [ Business Case Books & Tools ] [ Home ]
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 Gross sales revenues.................33,329 Gross profit.................................10,940 Operating expenses Operating income before taxes............... 3,130 Financial revenue & expenses Income before tax & extraordinary items..... 2,737 Extraordinary items Net Income (Profit).......................... 2,126 |
[ Page Top ] [ Encyclopedia ] [ Business Case Books & Tools ] [ Home ]
[ Pacioli ]
© Copyright Solution Matrix Ltd. 2004 - 2010
