Why Is The Cost Of Goods Sold So Important?

cost of goods sold

Many individuals start businesses, however, few achieve profitability. Many costs exists in starting and maintaining operations. The cost of goods sold (COGS) is among the most important measurement of successful businesses.

What Is Cost Of Goods Sold?

cost of goods sold
Cost Of Goods Sold Shows The Amount It Costs To Produce Goods

Cost of goods sold measures the costs associated with purchasing or manufacturing materials that a company uses for sales. Additionally, this is significant because it measures only those costs that directly impact production costs. Advertising or administrative expenses have no bearing on the production.

Furthermore, analysts find this measure imperative for a few reasons. We know that a company cannot make money without a sale. Sales – COGS = gross profit, and Sales / COGS = gross margin. These two calculations show how efficiently a company makes the products they sell. Therefore, if a company sees increasing gross margins, they are inherently more valuable.

Calculating COGS

Additionally, COGS is measured over a period of time, either quarterly or yearly. It requires inventory measurements, which reside in the income statement. The calculation is simply:

COGS = Beginning Inventory + Purchases in period – Ending Inventory.

These measures are self explanatory, except for beginning inventory. Beginning inventory shows inventory left over from the previous period, such as unsold items.

 Cost Of Goods Sold In Practice

Furthermore, analysts, investors, and management keep a very close eye on this measure as the trend over time shows increasing or decreasing profitability. Since this is the first measure of the income statement, it impacts every line item below it.

Also, it inherently shows how well the company manages inventory. Inventory turnover is an important metric for companies as an other operating efficiency measure. The best recipe for success exists when companies have low cost of good sold and high inventory turnover.

Final Thoughts

In conclusion, cost of goods sold is the pulse of companies. It shows how profitable they are relatively, and shows how profitable they are able to be. When management mentions decreasing COGS, stock pricing typically react positively.

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