Cost of Goods Sold

COGS captures only the direct costs of producing what was sold: raw materials, direct production labor, and factory overhead (utilities and depreciation tied to manufacturing). It excludes operating expenses like SG&A, R&D, marketing, and executive salaries — those sit further down the income statement and are not part of producing a unit. The dividing line matters: a cost is in COGS only if it varies with production volume and is directly attributable to the good sold. For a services or software business, 'cost of revenue' replaces COGS and includes hosting, support, and the salaries of staff delivering the service.

COGS is the bridge between the balance sheet and income statement for inventory. When inventory is sold, its cost moves from the inventory asset on the balance sheet to COGS on the income statement (the matching principle — recognize the cost in the same period as the related revenue). The cost flow assumption matters: FIFO (first-in, first-out) expenses the oldest inventory first, while LIFO (last-in, first-out, US GAAP only) expenses the newest. In an inflationary environment, LIFO produces higher COGS, lower reported profit, and lower taxes — a frequent technical question. This linkage is also why inventory turnover is calculated using COGS, not revenue.

COGS drives gross margin (gross profit / revenue), the cleanest read on a company's pricing power and production efficiency. A rising gross margin signals scale economies or premium pricing; a falling one flags cost inflation or competition. Because COGS sits above EBITDA and EBIT, it flows all the way down to net income, making it a critical driver in any operating model. In an LBO or DCF, modeling COGS as a percentage of revenue is one of the first assumptions you set, and a small margin improvement compounds dramatically into free cash flow.