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 headquarters costs. It also includes research and development (R&D). Figure 3 shows distribution costs being part of this area (along with being part of COGS). This is because some companies include part or all their distribution costs in the operating costs section. Walmart, for example, includes the costs of operating its distribution centers in operating costs, not COGS.
Customer service is also an operating cost. This is an area that is directly related to supply chain management as customers may inquire about the delivery date of their order or to initiate a return. It is not uncommon for part or all of the customer service organization to be in the supply chain organization. Finally, marketing and advertising – while being part of the marketing organization – are critical inputs to demand management, which is a vital process in the overall management of supply chains.
Data Service Differences
Data services available on the internet provide access to current and historical financial information for public companies. These services are used to analyze and compare companies. It is well documented that different data services may have different metric values for the same company. Why is this?
Data services typically develop a common format for a company’s income statement, cash flow statement, and balance sheet. They then take the data from a specific company’s financial statements and force it into the common format. Each data service has its own common format that may be slightly different from others. Thus, metrics reported by one data service may have slightly different values from those same metrics reported by another data service. Furthermore, the formulas for the metrics themselves may be slightly different across data services.
For example, two different data services may report different gross margins for the same company. This is because they have defined COGS differently for those companies. Inventory turns for such companies will likewise be different. Therefore, when using a data service for comparing companies, it must be noted how things are defined.
Furthermore, companies within an industry may choose to define COGS differently. In the retail industry for example, Target includes distribution center costs in its COGS, while Walmart does not (as discussed earlier). Walmart specifically states in its financial reporting that care must be taken when comparing its gross margin to others in the industry because Walmart's definition of COGS may be different from other retailers.
There are some data services that rely on extensible business reporting language (XBRL) tags to pull data from company financial reports. For example, if a company placed a “COGS tag” against a cost element, these data services would include those elements in their COGS line item. Theoretically this is a better way to go, since it is merely reporting what the company itself is “tagging” as a data element. However, XBRL tags for certain elements within a company often lack detail; furthermore, such tagging is inconsistent across companies due to different implementations of XBRL. That said, XBRL is a significant step forward and an excellent means by which to analyze individual companies.
Conglomerates and Companies with Multiple Divisions
Sometimes companies compete in more than one industry. Amazon, for example, has multiple businesses: internet retail, brick and mortar retail, cloud computing, video, and advertising. However, data services will almost always assign Amazon an industry code associated with retail, because that is where a high percentage of its revenue is derived. However, that may not be where a high percentage of its profit is derived. When comparing Amazon with other retailers, this profit from non-retail divisions may lead to inaccurate conclusions. This is true of numerous companies across different industries. (Note: Amazon breaks out financial information for its various businesses, so it’s possible to isolate metrics for its retail businesses; it does a better job of this than most multi-industry companies. Data services do not typically provide this level of detail; you must manually dig into company 10K financial statements for this information).
Industry Differences
As discussed earlier, companies in some industries do not have an explicit line item for COGS on their income statement. These are typically industries that do not make or sell a physical product. Figure 4 highlights the supply chain-related industries in which companies typically have a COGS line item and those in which companies typically do not. (Note: this is generally but not always true. Specific companies may or may not follow the general case expressed in Figure 4).
Figure 4 – Supply Chain-Related Industries with and without COGS Line Item on Income Statement
For companies that do not have a COGS line item, COGS is derived by using the earlier definition. Typically this means adding up all cost line items that are not associated with selling, general and administrative costs or research and development costs. This allows for a fair company-to-company comparison.
Gross Margin – A Key Metric Associated with COGS
Gross margin is the amount of revenue left after subtracting COGS. It is the markup that a company places on the product or service it produces; as such it is also a measure of pricing power. It is expressed as a percentage of revenue by dividing it by revenue:
Gross Margin = (Revenue - COGS) / Revenue
Another way to look at gross margin is that is the amount left over to pay for sales, marketing, administration, and research and development and then allow for an operating profit. For example, R&D intensive industries will want to generate high gross margins to continue to competitively invest in new products.
You can get a general sense of the operations of a company by simply looking at its gross margin. Companies with high gross margins tend to make products with high levels of intellectual property along with low material and labor content. Figure 5 shows the aggregate gross margins of supply chain related industries (those industries associated with making, moving, and storing physical products).
Figure 5 – Aggregate Gross Margins of Supply Chain-Related Industries (TTM as of October 2022)
Pharmaceuticals, telecommunications, and medical equipment are industries that make products and services with significant IP content and relatively low material and labor content (across all industries, including non-supply chain industries, software is the industry with the highest gross margin, owing to its high IP content and practically zero material content).
Industries with low gross margins tend to buy a lot of material and have a high labor content that adds value to those materials. For example, the automotive industry is an example of a low gross margin industry. An automotive company might spend 50%-60% of revenue on purchased materials and another 20%-30% on labor to add value to the materials.
Figure 5 shows that wholesale distribution is the lowest gross margin industry among supply chain industries. In this case, wholesale distribution does not make a product. Wholesale distributors typically purchase finished products and then store and transport them to customers. As such, it is a relatively low IP industry that adds incremental value on top of an already-produced product. Since COGS is made up of purchased finished products, a lot of the value to the product has been added upstream.
Inventory Turns – Another Key Metric Associated with COGS
Inventory turns has historically been among the key metrics associated with managing supply chains. It represents how fast a company turns materials into cash. The equation is simply stated as follows:
Inventory Turns = COGS / Inventory
COGS is an income statement line item and thus is based on a time period (typically an annual number); Inventory is a balance sheet line item and is thus a point-in-time measure. Therefore, a more accurate calculation of inventory turns is to use the average inventory position over the time period for which COGS is used (typically an annual number). In our analyses, we use an inventory number pegged to the end of the time period for COGS (for example, if COGS is used for the last fiscal year, then the end-of-fiscal year inventory position is used; we do this to simply calculations over a large data set).
Figure 6 – Aggregate Industry Inventory Turns (TTM as of October 2022)
Figure 6 shows aggregate inventory turns (aggregate COGS/aggregate inventory) for supply chain-related industries. Industries with the highest turns are restaurants, transportation, and telecommunications. Restaurants consume a lot of materials, but it is a perishable material and must be turned very quickly. Transportation and telecommunications are service-oriented industries that are more asset-focused and do not carry a lot of inventory.
Industries with the lowest inventory turns include aerospace and defense (A&D), pharmaceuticals, consumer goods, and hitech semiconductors. A&D makes a high-priced product in low volume with a slow pace of production. The pharmaceutical and semiconductor industries make products with high IP and high gross margin, contributing to lower inventory turns. For a discussion of industry inventory turns see Inventory Turns Ain’t What They Used to Be.
Final Word
Detailed supply chain costs are difficult to discern from a company’s financial statements. The first place to start is to look at cost of goods sold (COGS) and any accompanying notes that give insights into how a company accounts for supply chain costs. COGS and gross margin can give quick insights into the operating model of the company, the types of products it makes, and its pricing power, particularly when compared to similar companies.
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