Definition
Cost of goods sold is the core cost of making or buying the products or services you actually sold. It covers raw materials, factory labor, and indirect factory costs, but only the share that belongs to items that were sold.
The Secret of Cost, Told Through a Snack Cart
Picture a street cart selling bungeoppang, a fish-shaped Korean pastry with sweet red bean filling, for 1,000 won (about 70 cents) each. To bake one, you need batter, red bean paste, and gas for the griddle. If the direct cost of making one pastry is 400 won, that 400 won is the cost of goods sold for that pastry.
Here is one very important rule. Say you bought enough ingredients for 100 pastries today, but you only sold 60 before closing. You count only the ingredients for those 60 as cost. Only the share that was actually sold gets matched against that day's sales and written off as an expense.
So what happens to the ingredients for the 40 unsold pastries? They are not a lost expense. They stay on your books as inventory sitting in storage, ready to be sold tomorrow.
Don't Mix It Up with SG&A
When you run a shop, you spend money on more than the ingredients. Printing flyers to attract customers, delivery app fees, the monthly rent, and the cashier's pay are all typical examples. Do these all count as part of the cost of making your product?
The answer is no. These expenses don't go into making the product itself. They go into promoting it and keeping the business running, so they get a separate label: selling, general and administrative expenses (SG&A). Accounting draws a strict line between money spent on the product and money spent on keeping the company going.
If you charge 1,000 won and subtract the 400 won cost of goods sold, 600 won is left. That is called gross profit. Then you subtract 300 won of SG&A, such as the shop's rent, and only then do you get the shop's operating income from its main business: 300 won. Interest and taxes haven't been subtracted yet.
A Little More Precisely
To be a bit more precise, a company's books calculate it with a neat subtraction formula: beginning inventory + purchases during the period (or, for a manufacturer, the cost of goods manufactured during the period) - ending inventory. It looks complicated, but if you open the warehouse door and look inside, the idea is simple.
Start with the stock that was sitting in the warehouse at the beginning of the month. Add everything the factory newly made and put in this month. Then check the warehouse at the end of the month and subtract the stock that is still unsold. What's left is exactly the cost of the goods that were actually sold that month.
If goods the factory made are still piled up in the warehouse, they don't count as cost. They stay on the books as an asset. Fixed manufacturing costs, like factory equipment, don't depend on how much you produce, so they get spread across the number of units made. That means a company that isn't selling much but keeps the factory running full speed and piles up inventory ends up with a lower cost per unit. Part of the expense moves into inventory, and profit can look bigger than it really is.
Common misconceptions
All the raw materials you bought this month to make goods become this month's cost of goods sold.
Materials that haven't been sold and are still in the warehouse aren't an expense. They are 'inventory.' Only the material costs for goods that were actually sold count as cost of goods sold.
Where you meet it
At a coffee shop, it's the price of the beans, the paper cup, and the straw that went into one Americano you sold.
For a smartphone maker, it's the cost of the semiconductor chips and display parts that went into assembling one phone.
In one sentence
Cost of goods sold is the core cost of making or buying the products you actually sold.