Is Cost of Goods Sold an Operating Expense?

The income statement is a fundamental financial document that provides a comprehensive overview of a company’s financial performance over a specific period. It details revenues earned and expenses incurred, ultimately revealing the company’s net profit or loss. Correctly classifying these various expenditures is important for accurately assessing a business’s financial health and operational efficiency.

Understanding Cost of Goods Sold

Cost of Goods Sold (COGS) represents the direct costs tied to the production of goods sold or services rendered by a company. These expenses fluctuate with the volume of production, increasing as more units are produced and sold. Common components of COGS include the cost of raw materials used in manufacturing, the direct labor wages paid to employees actively involved in the production process, and manufacturing overhead directly related to production. For example, in furniture manufacturing, COGS includes wood, screws, varnish (direct materials), carpenters’ wages (direct labor), and factory utility costs or equipment depreciation directly linked to production. It excludes indirect costs like administrative salaries or marketing expenses.

Understanding Operating Expenses

Operating expenses are the costs a business incurs during its normal operations that are not directly associated with the production of goods or services. These expenses generally do not change significantly with small fluctuations in production or sales volume. Examples include administrative staff salaries, rent for office spaces, utility costs for non-production facilities, marketing and advertising expenditures, research and development costs, and depreciation of office equipment. These costs are often categorized as selling, general, and administrative (SG&A) expenses on financial statements.

How COGS and Operating Expenses Differ

Cost of Goods Sold is distinct from operating expenses because COGS represents direct costs of production, while operating expenses are indirect costs of running the business. COGS is directly linked to the revenue generated from sales, meaning these costs are incurred only when a product is made and sold. Operating expenses, conversely, are incurred regardless of sales volume, as they are essential for maintaining ongoing business operations. Revenue is first reduced by COGS to calculate a subtotal known as Gross Profit; subsequently, operating expenses are deducted from Gross Profit to arrive at Operating Income (also referred to as Earnings Before Interest and Taxes or EBIT). This structured presentation illustrates that COGS is a direct cost of product creation, preceding the calculation of gross profitability, while operating expenses are the costs of business management.