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Cost Of Sales vs COGS: 8 Ways To Differentiate The Terms


8 key differences between the cost of sales and COGS

Although many people use the cost of sales and COGS interchangeably, there are 8 key differences between the two terms. These differences should elucidate that, though using the cost of sales and COGS interchangeably is somewhat common practice, doing so can be misleading. If anything, using one value in place of the other may actually deceive you if thinking your processes are working well and they’re actually needing improvement. Here’s why.

1. Direct vs. indirect costs

The cost of sales includes the direct and indirect costs your small business incurs when selling products or services. COGS refers to the direct costs of solely the production of products or services.

2. Income statement placement

COGS on an income statement appears after your small business’s revenue. The cost of sales appears before the operating margin.

3. Breadth of terms

The cost of sales encompasses far more than COGS does. The cost of sales assesses your small business’s entire inventory, whereas COGS looks solely at your production costs.

4. Tax deductibility

While COGS and cost of sales are sometimes seen as synonymous terms, conflating the two can cause further issues come tax time. That’s because COGS is tax-deductible, whereas the cost of sales is not.

5. Calculation methods

To calculate COGS, you must know the total amount of products or services that your business creates during an accounting period. The cost of sales, on the other hand, reflects the total amount of products or services that are not just created but successfully sold.

6. Never the same value

Since the cost of sales factors in additional costs to those included in COGS, the cost of sales will always be greater than COGS. These additional costs pertain to what you must do with your products after you create them to ensure they’re actually sold.

7. Sales vs. manufacturing

The cost of sales indicates how much money goes into selling products that you’ve already manufactured. COGS indicates solely the cost of your manufacturing whether or not the goods are sold. This distinction is also why the cost of sales is always higher than COGS. You can’t just manufacture something and expect it to move units – you need to spend extra money on marketing.

8. Use cases

Retailers and service providers should use the cost of sales on their income statements. Manufacturers should use COGS. A company that provides both services and tangible products can use the cost of sales for the former and COGS for the latter.

6 things you must know to calculate COGS

To calculate COGS, you need to have the following information:

1. Valuation method

Your COGS will depend on which valuation method you use for your inventory. You have three choices:

  • First in, first out (FIFO). Using FIFO, your small business will first sell the products or services it has created the earliest. When the FIFO method is used, a lower COGS value may result since product and service prices tend to increase with time.
  • Last in, first out (LIFO). LIFO is the opposite of FIFO: The products or services created most recently are sold first. Since the prices of these items may be higher, a larger COGS value may result.
  • Average cost method. In the average cost method, the age of products and services is irrelevant. Instead, the average price of all products and services in stock determines the value of COGS.

2. Beginning inventory

Your beginning inventory includes:

  • All merchandise you keep in stock
  • Raw materials
  • Products and services in progress
  • Finished products and services
  • Additional supplies provided with your goods and services

Note that your beginning inventory at the start of a tax year must be exactly the same as your ending inventory for the prior tax year. If they are not the same, you will need to file a written explanation to the IRS along with your annual tax forms.

3. Cost of labor

To determine the cost of labor for your tax year, add together all payments to employees involved in creating your products or services. Exclude payments to employees who only sell your products or services; their work is factored into your cost of sales accounting, not COGS.

4. Cost of purchases, materials, and supplies

Any purchases, materials, and supplies you must make to create your products or services should be included in your COGS calculations. COGS on your income statement will reflect all expenses, including these purchases, involved in your business’s production operations.

5. Other costs

Any other costs associated with creating your products or services, such as rent for the office or laboratory space in which your services are offered, or your products are created, should be included in your COGS calculations.

6. Ending inventory

You can determine your ending inventory costs by taking a physical inventory, or at least an estimate, of your products and services. Then, as with your cost of sales calculations, to determine COGS, you should subtract the costs of your ending inventory from the labor, purchases, materials, supplies, and other costs you have added to your beginning inventory.

You should notice that your COGS value will differ significantly from your cost of sales value. That’s how you’ll know you’ve properly calculated both these vital business metrics and are on your way to a thorough, accurate income statement.

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