Cost of goods sold (COGS) is the direct cost of selling an item. For a retail business, cost of goods sold represents the inventory acquisition cost. For a manufacturing business, cost of goods sold is the direct costs of manufacturing the item.
Cost of goods sold is also called cost of sales or cost of merchandise sold.
For a firm which sells acquired inventory, such as a retailer or wholesaler, the firm must make an inventory cost flow assumption. The inventory cost flow assumptions are last-in, first-out (LIFO), first-in, first-out (FIFO), and the average cost method.
Inventory cost flow assumptions are used because firms often pay different prices for the products they acquire and sell. These firms must make an assumption as to which goods are being sold. For example, suppose a firm acquires 100 items and sells 80 of these items. These items may have been purchased at different prices. Thus, the firm must make an assumption as to which items are being sold. Under the LIFO method, the firm assumes the most recent purchases are sold first. Under the FIFO method, the firm assumes the oldest purchases are sold first. Under the average cost method, the firm takes an average of the different acquisition costs.
For a manufacturing firm, inventory is manufactured in-house and thus reflects the costs of manufacturing the item. These costs include direct labor, direct material, and allocated overhead.
Cost of goods sold is one component in calculating a firm’s gross profit. Gross profit is calculated by subtracting cost of goods sold from revenue.
