Are Sales Commissions Part of Cost of Goods Sold?
Understand the financial reporting of sales commissions. Learn why they are typically excluded from Cost of Goods Sold and their proper classification.
Understanding how expenses are categorized is fundamental for accurate financial reporting and informed decision-making. Proper classification ensures that financial statements truly reflect a company’s performance and financial health. A common question is whether sales commissions should be included as part of the Cost of Goods Sold (COGS). This distinction carries significant implications for a company’s gross profit and overall profitability.
Defining Cost of Goods Sold
Cost of Goods Sold (COGS) represents the direct costs a company incurs to produce the goods it sells during a specific accounting period. This metric is a central component of the income statement, appearing directly below revenue.
Typical components included in COGS are the cost of raw materials that become part of the finished product, the direct labor involved in the manufacturing process, and manufacturing overhead. Manufacturing overhead encompasses costs like factory utilities, depreciation on production equipment, and indirect factory labor. For businesses such as manufacturers, retailers, and distributors, COGS directly impacts gross profit, which is calculated by subtracting COGS from total revenue.
Defining Sales Commissions
Sales commissions are compensation provided to sales personnel for achieving sales goals or generating revenue. This variable pay structure motivates sales teams and aligns their efforts with company revenue objectives. Commissions are typically calculated as a percentage of sales value, though they can also be a flat fee per unit sold or based on profit margins.
Common commission structures include a straight commission where earnings are solely based on sales, a base salary plus commission, or tiered commissions where the percentage increases as sales targets are met. The purpose of these structures is to incentivize sales professionals, encouraging higher sales volumes and revenue generation.
Distinguishing Direct and Indirect Costs
Understanding the classification of costs as either direct or indirect is crucial for financial accounting. Direct costs are expenses that can be specifically and directly traced to the production of a particular good or service. Examples include raw materials and the wages of workers directly involved in assembly. These costs generally vary with the level of production, increasing as more units are produced.
In contrast, indirect costs, often referred to as overhead, cannot be easily or directly linked to a specific product or service. These expenses are necessary for the overall operation of the business but do not directly contribute to product creation. Examples include administrative salaries, office rent, and utility expenses for the entire facility. This distinction relates to “product costs” versus “period costs.” Product costs are capitalized as inventory until sold, then becoming COGS, while period costs are expensed when incurred.
Classification of Sales Commissions
Sales commissions are generally not included in the Cost of Goods Sold. COGS specifically accounts for the direct costs associated with the production or acquisition of goods. Commissions, however, are expenses incurred in the sale of goods, occurring after the product is ready for market. They are considered an operating expense, falling under selling expenses.
These selling expenses, including sales commissions, are typically reported as part of Selling, General & Administrative (SG&A) expenses on a company’s income statement. SG&A expenses are indirect costs that support overall business operations but are not directly tied to manufacturing. While sales commissions are variable costs that fluctuate with sales volume, their nature as a selling expense places them outside of COGS.