Cost of Goods Sold: Why Should It Matter to You?

The cost of goods sold (COGS) for any company is the exact cost of raw materials and labor to produce a product. It is an accounting term used to determine how much a company actually profited from a sale. Since a company is taxed based on net profit and not gross sales, determining net profit based on COGS is essential to reducing taxes. For an investor considering a company, reviewing COGS versus gross sales can help you see inefficiencies and net profit.

Gross versus Net Sales

When you look at a company's financial statement, you should see two separate profit figures listed. The first will be a gross sales figure representing all of the cash the company brought in through goods sold to the public. The second figure will be a net profit, which is how much the company actually earned after paying for all the expenses it has. As an investor, you should be more concerned with the second number. You profit only if the company profits. If it simply pays for its operations through sales, there is no money left over to split with the shareholders. 

COGS as Efficiency Indicator

The difference between gross and net profit for an organization is not only attributable to COGS. COGS does not include the wages for any employee not involved directly in the production process of creating the good. For example, a car manufacturer will count a mechanic's salary as part of COGS if the mechanic puts together the vehicle. The company will not count the salesperson's salary, however, since this individual did not help manufacture the vehicle. Find the difference between gross and net profit. Take this difference and compare it to COGS. If the two figures are largely different, the company may be incurring extra expense in delivering the product to market.

COGS as Standards Indicator

Over time, the COGS for any company will change. The cost of raw materials fluctuates, as does the cost of labor. Companies may be offered discounts when they purchase larger orders, bringing down the COGS for an individual item. While these fluctuations are normal, a sharp change in the COGS can indicate a change in standards. The company may have chosen a new supplier of raw materials or a new manufacturing plant to service them. As an investor, you should want to know the source of the change and be comfortable with the decision.

COGS and Tax Liabilities

Finally, you should pay attention to COGS because it will impact the company's tax liabilities at year's end. If a large portion of costs can be written off, the company will have a relatively small taxable income. A very tax-efficient company will incur few costs after the product has been manufactured. If you are reading a report in the third quarter that indicates the company will have low tax liability due to a high COGS, you may have reason to believe the profits will be relatively high and that you will receive a good distribution.

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