Cost of Goods Sold: A Deeper Dive

In an earlier article, we provided a basic overview of cost of goods sold (COGS) and cost of services (COS). Now, let's take a closer look at what makes these financial classifications so tricky – particularly COGS.

It starts with shipping and packaging

Outbound shipping costs are a prime example of the murkiness involved when calculating COGS. To understand why, let's start with the IRS definition: "Containers and packages that are an integral part of the product manufactured are a part of your cost of goods sold. If they are not an integral part of the manufactured product, their costs are shipping or selling expenses."

For a real-world example of that distinction, consider the colorful cardboard trays where candy bars are displayed at checkout lanes in grocery stores. Each tray holds 20 individually wrapped candy bars, and many of them have a mini billboard-type display integrated into the tray that tries to catch your attention – and possibly your appetite. Obviously, you can't sell unwrapped candy bars, so the wrappers are an integral part of the manufacturing process of the salable product – and therefore are categorized under COGS. The colorful trays, however, clearly perform a marketing function. That means the IRS considers their cost part of those "shipping or selling expenses."

Seems pretty clear so far. Here's where it gets tricky. At big-box stores like Costco, the same candy bars are often also sold in 20-packs that look a lot like the cardboard retail display trays used at grocery store checkout lanes. But there's an important difference: The made-for-Costo 20-pack itself has a sales barcode on it, while each candy bar wrapper inside the carton says "Not labeled for individual retail sale."

According to the IRS definition, the cardboard packaging for the 20-pack product sold at Costco is an integral part of the manufacturing process and therefore its cost belongs in COGS – even though the packaging looks nearly identical to the cardboard trays used in grocery stores that are considered "shipping or selling expenses."

Even more shades of gray

For inventory-based businesses, the distinctions get even more granular further upstream. To palletize large production runs of candy bars for storage and transport, the manufacturer might bundle them into plain brown cardboard cartons. If each carton holds 24 of the 20-pack trays, that's 480 total candy bars in each carton. And perhaps the company can stack 50 cartons on each pallet before sending several shrink-wrapped pallets' worth of product over to their wholesale distributor or directly to a big-box reseller like Costco.

The cartons, pallets and shrink-wrap costs aren't part of COGS, and technically neither were the labor and equipment costs to stack the cartons onto pallets. Those costs, plus the cost of transporting the pallets to their next destination, are actually all shipping expenses that are part of overhead. The same is true for packing materials and postage to send individual or 20-pack trays of candy bars directly to ecommerce customers.

The cost of storing finished goods is officially part of COGS. But it's sometimes difficult to build that into the unit cost of an individual item. That's because the cost varies depending on the volume of goods being stored and how long they're stored before they're sold.

It may also be challenging for small brands to isolate certain other manufacturing and packaging costs and allocate them down to the individual finished goods' inventory unit cost. That's a particular challenge when working with third-party manufacturing and fulfillment partners across multiple product stock-keeping units (SKUs). So it's not uncommon to record some of those costs under COGS in lump sum instead of baking them into the unit-level finished goods inventory cost or splitting hairs to record certain warehousing costs outside of COGS.

And still more ways to spin those COGS

To complicate matters further, astute brands follow the accrual method of accounting. In other words, when they incur expenses to manufacture or procure resalable products, they first capitalize those expenses as inventory assets held on the company's balance sheet. When an individual unit of product is eventually sold, they subtract the asset value of that item from their balance sheet (because now the customer owns the product) and simultaneously record its value as COGS and record the price the customer paid as income. Wash, rinse and repeat for each individual unit sold, calculated precisely at the SKU level for every item in your catalog.

Businesses that carry large amounts of inventory on their balance sheets usually have to tie up large amounts of capital to pay for and store that inventory until it's sold. Some businesses borrow cash from an asset-based lender and use the inventory as collateral while it has value. That unlocks extra budget for the business to spend in other areas while waiting for the inventory to sell. But the lender needs confidence in the numbers to protect themselves in case they need to seize the inventory assets and resell them if the loan isn't repaid. So it's important to have your accounting dialed in if you want to go that route.

Sometimes the value of inventory can change between the time it was originally sourced and the time it eventually sells. For example, food inventory items that spoil after sitting in storage for too long are suddenly worth $0, commodities that follow market price fluctuations, or finished goods like electronics that become obsolete when a newer model is released. In those cases, the value of that inventory would need to be adjusted with a gain or loss posted to the company’s income statement. The new adjusted inventory value of those items would then impact the unit-level COGS when those items are eventually sold or disposed of.

Anything else?

COGS and inventory accounting go together like peanut butter and jelly. But manufacturing labor and raw materials costs (like the price of peanuts, fruit and sugar) can fluctuate, so the cost to produce or procure one batch of product may likely be different from the next. Accountants tend to use one of three standard methods for assigning dollar value to each new unit of inventory added, namely FIFO, LIFO and Weighted Average. QuickBooks Online can only handle FIFO ('first in, first out) right out of the box – if your business would be better served using a different inventory accounting method or if you don’t know which method is right for your business in the first place, phone a friend…preferably an experienced accountant. ;)

Services-based businesses don’t store products in inventory, but the labor costs they invest in billable work product can behave like inventory from an accounting perspective when they pay for that labor effort in advance of recognizing the corresponding revenue. Before those labor costs become COS, experienced accountants park them in a work in progress (WIP) asset account on the balance sheet – just like product inventory that is purchased before it is eventually resold.

You get the idea…

There are time-tested methodologies for businesses to manage all of these complex COGS-related challenges. Regardless of your particular type of business, those are best left to professional accountants.

Once you have your COGS and COS ironed out, read on to learn about Contribution Margin: The Hidden Key to Understanding Profitability!