COGS

COGS (an acronym for Cost of Goods Sold, also known as Cost of Sales) is a fundamental line item you'll find on a company's income statement. Think of it as the direct cost of doing business. It represents all the expenses directly tied to producing the goods or services a company has sold during a specific period. This includes the cost of raw materials (like the steel for a car) and the direct labor costs involved in making the product (like the wages of the factory workers on the assembly line). What’s crucial to remember is what COGS excludes: indirect costs. Things like marketing budgets, the CEO’s salary, headquarters' rent, and the sales team's commissions are not part of COGS. These are considered operating expenses. In essence, if you can’t make the product without this specific cost, it’s likely part of COGS. Understanding this distinction is the first step to seeing how efficiently a company turns its raw materials into cash.

For a value investor, COGS isn't just an accounting term; it's a treasure map pointing toward a company's profitability and competitive strength. Its primary role is in calculating a company’s Gross Profit, which is simply Revenue - COGS. This simple formula is incredibly revealing. A company that can consistently keep its COGS low relative to its revenue has a high Gross Margin ((Gross Profit / Revenue) x 100%). A high and stable Gross Margin is often a tell-tale sign of a powerful economic moat. It suggests the company has either incredible operational efficiency, strong pricing power (it can charge customers more without losing them), or both. Imagine you're a baker. The flour, sugar, and eggs for your famous cake are your COGS. If you find a cheaper, high-quality flour supplier, your COGS drops, and your Gross Profit on each cake rises. Or, if your cake is so legendary that people are willing to pay a premium for it, your revenue increases while your COGS stays the same, again boosting your Gross Profit. As an investor, you're looking for businesses that are masters of this equation.

While the concept seems straightforward, COGS is a cocktail of different costs. The main ingredients typically fall into three categories:

These are the tangible, raw ingredients that go into the final product.

• For Ford, it's the steel, glass, and rubber for its cars.
• For Hershey's, it's the cocoa beans, sugar, and milk.
• For a homebuilder, it's the lumber, concrete, and wiring.

These are the direct, variable costs that increase as the company produces more units.

This is the “D” in COGS's full name—Direct Labor. It refers specifically to the wages and benefits paid to the employees who physically touch the product during its creation.

• This includes the factory worker assembling a smartphone or the technician running a manufacturing machine.
• It does not include the salaries of the marketing team, the HR department, or the C-suite executives. Their salaries fall under Selling, General & Administrative (SG&A) expenses.

This is the trickiest part. It includes all the other manufacturing costs necessary to run the factory, but which aren't easily traced to a single unit. Think of costs like:

• Rent or property tax on the factory building.
• Electricity and water used to power the production line.
• Depreciation of the manufacturing equipment over its useful life.

These costs are allocated across all the units produced in a period.

Let's put this into practice with a fictional company, “Durable Denim Co.” In 2023, they reported the following:

• Revenue: €1,000,000
• COGS: €400,000

First, we calculate the Gross Profit:

• Gross Profit = €1,000,000 (Revenue) - €400,000 (COGS) = €600,000

Next, we find the all-important Gross Margin:

• Gross Margin = (€600,000 / €1,000,000) x 100% = 60%

A 60% Gross Margin is quite healthy! But the real insight comes from tracking this over time. If in 2022 their margin was 55% and in 2021 it was 52%, this tells a story of increasing efficiency or pricing power—a fantastic sign for an investor. Conversely, if the margin was trending downwards, it would be a red flag, prompting you to investigate whether their costs are spiraling out of control or if they are facing intense price competition.

While powerful, COGS is not without its nuances. Here are a couple of things to watch out for.

Companies have to make assumptions about which inventory costs to use when calculating COGS, and their choice can have a big impact. The two main methods are:

• FIFO (First-In, First-Out): Assumes the first inventory items purchased are the first ones sold. During periods of rising prices (inflation), this method results in a lower COGS because it uses older, cheaper costs, thus making profit appear higher.
• LIFO (Last-In, First-Out): Assumes the newest inventory items purchased are the first ones sold. In an inflationary environment, this results in a higher COGS, as it uses more recent, expensive costs, thus reporting lower (and often more conservative) profits.

It's important to check the company's annual report footnotes to see which method they use, especially when comparing two companies in the same industry. Note that LIFO is permitted under US GAAP but not under IFRS, which is used in Europe and many other parts of the world.

The classic COGS definition fits manufacturing and retail businesses like a glove. But what about a software company like Microsoft or a consulting firm? They don't have traditional “goods.” For these businesses, you'll see a line item called “Cost of Revenue” or “Cost of Sales.” The principle is identical: it captures the direct costs of providing the service.

• For a cloud computing business, this would include server costs, data center electricity, and salaries for the direct technical support staff.
• For a consulting firm, it would primarily be the salaries of the consultants working directly on client projects.

Always apply the same logic: are these costs essential for delivering the core product or service to the customer? If so, they belong in Cost of Revenue/COGS.