Cost of Goods Sold (COGS) and Supply Chain Management

COGS is the most important financial term in supply chain management. How is it related to SCM and how should we think about it?

Cost of Goods Sold (COGS) is a line item on a company’s income statement. It is the cost bucket where most supply chain costs are found. COGS is also referred to as “cost of sales,” “cost of revenue,” or “cost of products sold.” Companies that don’t design or make products will often use the term “cost of sales.” Other companies, in certain industries as described below, do not have an explicit line item called COGS or its equivalent. In these cases, COGS is derived from other cost line items; this is done so that company-to-company and industry-to-industry comparisons can be performed.

Let’s take a look at COGS in the context of supply chain management. We’ll start with a general overview of financial statements and their relationship to supply chain management.

Financial Statements - Relationship to Supply Chain Management

Company financial statements follow a common format, as dictated by accounting standards. There are three common financial statement components: the income statement, the balance sheet, and the cash flow statement. The income statement summarizes profit by netting costs from revenue. The balance sheet reflects the input assets necessary for creating revenue and profit. The cash flow statement nets the amount of cash that flows into and out of the corporation during the period of the statement. In general, over the long term, a company’s value is based on revenue and profit (income statement), and the level of assets (balance sheet) and the level of cash expenditures (cash flow statement) necessary for creating revenue and profit.

Although financial statements follow a common framework, there is a fair amount of deviation from company to company and industry to industry. Within an industry you will often see a reasonable amount of commonality, as new companies leverage the formats of older companies.

Each financial statement contains elements that are related to supply chain management. These elements are highlighted in Figure 1 below.

Figure 1 – Financial Statements and Elements Related to Supply Chain Management

Figure 1 provides a link between each financial statement and value driving areas associated with supply chain management. For example, cost optimization is associated with how best to reduce costs of goods sold, while at the same time growing revenues; asset optimization focuses on minimizing the physical assets necessary for making and moving product; and cash-to-cash optimization focuses on minimizing the amount of cash tied up in inventory, receipts, and payments.

COGS Definition

In our analyses we define cost of goods sold (COGS) as follows:

COGS are all the costs necessary to bring a product or service to the point where it can be used by a customer, except for development, selling, and administrative costs. We view COGS as everything you procure plus all the human and other activities that add value to the procured materials to transform them into a product or service.

Figure 2 provides an overview of COGS versus operating costs. In general, COGS are all costs except operating costs; operating costs include selling, general and administrative (SG&A) and research and development (R&D) costs. It should be noted that not all companies adhere to this definition and may include some elements of COGS (as outlined in Figure 2) in their operating costs. Furthermore, some industries (as discussed below) generally do not use COGS as an income statement line item. In those cases, COGS is derived from an aggregation of cost elements (more on this below).

Figure 2 –Elements of COGS versus Elements of Operating Costs

It should be further noted that some companies allocate depreciation and amortization costs across different cost buckets, while others have a separate income statement line item for depreciation and amortization. Companies in asset intensive industries, where depreciation and amortization costs are high, typically have a depreciation and amortization line item that is included in operating costs (not cost of goods sold).

In the retail industry, in most cases, the cost of store operations is included in selling, general and administrative (SG&A) costs. This makes sense since stores are a primary selling vehicle for retailers.

Supply Chain Costs

Figure 3 provides an overview of supply chain and related costs and where they are typically found in three of the principal areas of an income statement: revenue, COGS, and operating costs.

Figure 3 – Supply Chain and Related Costs – Relationship to Income Statement Line Items

Here we provide an overview of cost elements identified in Figure 3.

Revenue

Revenue is the top line of an income statement. That is why you often hear the phrase “improve the top line,” which refers to putting in place measures to increase revenue. When it comes to supply chain management, Figure 3 identifies three key elements related to the top line: trade promotions, markdowns, and returns. All are deductions from the top line and have a significant influence on the management of supply chains.

Trade promotions are periodic price reductions that are designed through a collaboration between manufacturers and retailers. They often follow a seasonal / events pattern but can often be executed as a result of potential revenue shortfalls or competitive pressures. In the automotive industry, these have traditionally been called incentives. You will often find on the window sticker of a new car a line item called “manufacturer incentive.”

Manufacturers often account for promotions and incentives using an accrual. For example, they sell products to a retailer (or dealer) during a given quarter, but they don’t know yet what the final sales price will be to the end consumer. In this case, in order to capture current quarterly sales accurately, they estimate how much the incentive will be. When the sales fully come in, they adjust it in future quarters.

Incentives are used heavily in the automotive industry. Historically, automotive OEMs have had multi-billion-dollar incentive budgets. One of the reasons automotive OEM operating margins have been historically high in the past 24 months is that their incentive budgets have been reduced dramatically with the result falling to the bottom line.

Markdowns have a negative connotation because they are often associated with clearing unwanted inventory. These price reductions are tied to the aging of inventory, lack of appeal of a certain product, and demand forecasts that exceed actual demand, resulting in excess inventory.

COGS

Figure 3 shows the primary elements of COGS, all of which are related to supply chains. There is a flow to these costs: material is procured; it is then transformed through a manufacturing or other process; it is then managed in inventory as a finished product and then transported to intermediate locations and ultimately to the customer. After that, it may also be returned. Returns are a double-whammy – a reduction in revenue along with the costs of transporting, storing, and restocking or disposing of the item (there may be some revenue recapture if the item can be resold).

Inventory carrying costs include storage, obsolescence, shrinkage, insurance, handling, management, and financial costs. These costs can also be considered distribution costs. Financial costs are typically the cost of money over the time in which the inventory is held. This includes the cost of financing the inventory (if it is financed) and the opportunity cost for the money that is tied up as inventory. This is typically a company’s weighted average cost of capital (WACC) multiplied by the value of inventory held (this is a yearly time bucket, so it’s the average inventory position for the year multiplied by WACC). (Note: WACC and inventory financing costs fluctuate with interest rates; the low interest rate environment in the decade up to 2022 led to lower inventory carrying costs. Since then, carrying costs have been rising).

Operating Costs

Figure 4 also shows supply chain related costs that are part of the operating costs section of a company’s income statement. In general, operating costs include sales and marketing, finance, customer support, human resources, executive management, and other he