Cost of goods sold (COGS)

Cost of goods sold (COGS) or cost of sales refers to the direct costs of producing the goods sold by a company. This amount includes the cost of the materials and labour directly used to create the goods. It excludes indirect expenses, such as distribution costs and sales force costs.

Why break it into direct and indirect costs?

By subtracting the direct costs, which is COGS, which is associated directly with the production of a product or service from revenue, a business is able to know exactly how much goes into what they are selling. In most cases revenue and cost of goods sold increase proportionately as a business would produce more as they sell more, but things like economies of scale may cause COGS to be less.

Calculating direct costs separately also allows Gross Profit margin to be calculated which is a metric that shows how much of revenue is remaining after accounting for direct expenses. This can give a business an idea of how much profits they would stand to make after accounting for all other expenses.

Businesses also use gross profit margins to compare themselves to competitors in the industry to see where they stand.

Most service businesses do not have direct expenses at all, which is another reason to have these costs broken up.

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