The cost of goods sold (COGS) is a component of the value of a company’s inventory. Inventory and cost of goods sold have a directly dependent relationship in practice and on the books. In practice, a company cannot have inventory without also having proportionate costs that allowed it to generate that inventory. On the books, the COGS is subtracted from revenue to establish gross margin, or the amount of profit made on the sale of the company’s inventory.
COGS is an expense category that compiles all of the direct costs incurred to produce and sell a company’s products, or the direct costs of turning inputs into revenue. Depending on the type of business being studied, the relationship between inventory and cost of goods sold can be more or less complicated. For example, for a manufacturing business, this includes the cost of raw materials, direct labor costs to produce the goods, the proportion of facility costs that can be directly assigned to the manufacturing process and the direct cost of the sales force used to sell the goods.
In a retailing business, however, the COGS is simply the cost of buying inventory from a wholesaler or manufacturer, the cost of preparing it for sale and the cost of selling it. The relationship between the two in a manufacturing setting is somewhat more complex. Typically, it is easier in a retail setting to segment out the appropriate costs that should be assigned to the COGS category.
The most relevant connection between inventory and COGS is the way the two relate to establish a company’s profitability. Revenue is the amount of money a company takes in as a result of selling its products. This number is important, but it does not reflect whether a company is making money or losing money. Profitability can only be determined once a business owner subtracts out the costs incurred in generating that revenue.
At the most basic level, a company needs to know its gross margin, or the profit made on turning over its inventory before it considers additional expenses like taxes. To figure this out, the cost of producing and selling the inventory, or COGS, is subtracted from revenue. Inventory and cost of goods sold are inextricably connected in this analysis because the use of the value of these two categories exposes basic business facts, such as whether an owner is pricing his goods for sale at a level that will make him a profit.