Cost of Goods Sold (COGS)

Cost of Goods Sold (also known as 'COGS' or 'Cost of Sales') is a line item on a company's Income Statement that represents the direct costs attributable to the production of the goods it sold during a specific period. Imagine you run a small business printing custom t-shirts. Your COGS would include the cost of the blank shirts, the ink used for printing, and the wages of the person operating the printing press. It's the “cost of the stuff” that you sold. Crucially, it does not include indirect costs like marketing salaries, rent for your head office, or the cost of your accounting software; those are separate expenses. For a value investor, COGS is one of the most important figures to understand. It sits right below Revenue on the income statement, and subtracting it gives you a company's Gross Profit—the first and purest measure of a company's profitability before all other corporate overhead gets in the way.

For a value investor, a company's COGS tells a story about its efficiency and competitive strength. A business that can consistently keep its COGS low as a percentage of its sales is a well-oiled machine. It suggests the company has strong relationships with suppliers, efficient production processes, or perhaps the ability to raise prices without scaring away customers—a hallmark of a strong brand. Analyzing the trend of COGS over many years is like taking an X-ray of a company's core operations. If sales are growing but COGS is growing even faster, it's a red flag. This could mean the company is losing its pricing power or that the costs of its raw materials are spiraling out of control. On the other hand, a company with a stable or shrinking COGS relative to sales often possesses a durable Competitive Moat. It can protect its profitability from the ravages of inflation and competition, making it a potentially wonderful business to own for the long term.

Understanding what goes into the COGS calculation helps you appreciate what it truly represents. While the specifics can vary by industry, the main ingredients are generally the same.

• Raw Materials: This is the cost of the basic parts used to create a product. For a car company, this would be steel, glass, and rubber. For a software company that sells physical copies, it might be the discs and packaging. For most service or pure-tech companies (like Google or Facebook), this line item is often zero or negligible, which is one reason they can be so fantastically profitable.
• Direct Labor: These are the wages paid to the employees who are directly involved in making the product. Think of the factory worker on the assembly line or the baker kneading the dough. It does not include the salary of the CEO, the marketing team, or the HR department. Those costs fall under a different category called SG&A (Selling, General & Administrative expenses).
• Manufacturing Overhead: These are costs that are directly related to the production facility but not to a single specific unit. This includes things like the factory's electricity bill, rent for the production warehouse, and maintenance on the machinery.

While you can usually find COGS listed directly on the income statement, it's helpful to know how it's calculated. This knowledge is especially useful when digging into a company's inventory management.

Accountants calculate COGS for a period (like a quarter or a year) using a simple formula: COGS = Beginning Inventory + Purchases during the period - Ending Inventory Let's break that down with our t-shirt business example:

1. You start the year with $1,000 worth of blank shirts (Beginning Inventory).
2. You buy another $5,000 worth of shirts and ink during the year (Purchases).
3. At the end of the year, you count what's left and find you have $1,500 worth of supplies (Ending Inventory).
4. Your COGS would be: $1,000 + $5,000 - $1,500 = $4,500. This is the cost of the specific goods you actually sold.

COGS is the essential input for two of the most powerful profitability metrics available to an investor.

• Gross Profit: This is the money left over after you've paid for the products you sold. The formula is simply: Gross Profit = Revenue - COGS. It tells you how much money the company is making from its core business activity, which it can then use to pay for everything else (marketing, research, taxes) and hopefully leave something for shareholders.
• Gross Margin: This is perhaps the more useful metric, as it allows for easy comparison between companies and over time. It turns Gross Profit into a percentage of revenue: Gross Margin = (Gross Profit / Revenue) x 100%. A company with a consistent and high Gross Margin (say, 60%) is far more profitable at its core than a company with a low Gross Margin (say, 15%).

When you open a company's annual report, don't just glance at the COGS number. Interrogate it. Here are a few questions to guide your analysis:

1. Is the Gross Margin stable or growing? Calculate the Gross Margin for the last 5-10 years. A business with a wide, stable margin is often a fortress. A shrinking margin is a warning sign that its competitive position may be eroding.
2. How does it compare to its rivals? Look at the Gross Margins of the company's closest competitors. A company with a significantly higher margin than its peers likely has a special advantage—be it a better brand, a patent, or a lower cost structure. This is a fantastic starting point for further research.
3. How are they accounting for inventory? Dig into the footnotes of the financial statements to see if the company uses LIFO (Last-In, First-Out) or FIFO (First-In, First-Out) accounting. During periods of rising prices (inflation), LIFO will result in a higher reported COGS (and lower profit), while FIFO will show a lower COGS (and higher profit). Understanding which method is used can help you make more accurate comparisons between companies.
4. How sensitive is COGS to commodity prices? If you're analyzing an airline, how much does a 10% rise in oil prices impact its COGS? If you're looking at a cereal maker, what about the price of wheat? A great company often finds ways to hedge against or pass on these rising input costs, protecting its Gross Margin.