Is Overhead Included in Cost of Goods Sold?
Demystify how various overhead costs are treated within Cost of Goods Sold and their impact on financial reporting.
Businesses incur various costs to operate and generate revenue. Understanding how these costs are categorized and reported is fundamental for accurate financial statements and informed decision-making. This process is especially important for companies that produce goods, as it directly impacts how their product costs are accounted for and presented.
Components of Cost of Goods Sold
Cost of Goods Sold (COGS) represents the direct costs incurred in producing goods or services that a company sells. COGS focuses on expenses that would not exist if no products were produced.
The primary components of COGS typically include direct materials, direct labor, and other direct costs. Direct materials are the raw goods that become an integral part of the finished product, such as steel for an automobile manufacturer or flour for a bakery. Direct labor encompasses the wages and benefits paid to employees directly involved in the production process, like assembly line workers. Other direct costs are specific expenses that can be directly attributed to the production of a particular good, such as freight-in costs for raw materials.
Defining Overhead Costs
Overhead costs are indirect expenses necessary for the general operation of a business but are not directly traceable to the production of a specific product or service. These costs are incurred regardless of the production volume. Overhead can be broadly categorized into manufacturing overhead and non-manufacturing overhead.
Manufacturing overhead includes all indirect costs related to the production process within a factory setting. Examples include factory rent, utilities, equipment depreciation, and supervisor salaries. These costs are essential for manufacturing but do not become a physical part of the product.
Non-manufacturing overhead, also known as operating or SG&A expenses, relates to activities outside of direct production. This category includes office rent, marketing, administrative salaries, and sales commissions. These expenses support the overall business infrastructure rather than manufacturing goods.
Manufacturing Overhead and COGS
Manufacturing overhead is included in the calculation of Cost of Goods Sold. This is a fundamental accounting principle, recognizing these indirect production costs are integral to creating a product. While direct materials and direct labor are easily traced, manufacturing overhead is still a necessary production expense.
These indirect factory-related costs are allocated to goods produced and become part of inventory cost. For instance, factory electricity, depreciation on production machinery, or maintenance personnel wages are manufacturing overhead costs capitalized into inventory. When manufactured goods are sold, these allocated manufacturing overhead costs are expensed as part of COGS. This ensures the full cost of producing sold goods is accurately reflected.
Conversely, non-manufacturing overhead costs are not included in COGS. These expenses are related to selling, general, and administrative activities and are treated as period costs, expensed on the income statement in the period they are incurred. For example, marketing campaign costs, executive salaries, or corporate office rent are considered non-manufacturing overhead. These costs are deducted separately from gross profit to arrive at operating income, as they are not directly tied to producing sold goods.
Impact on Financial Statements
Properly classifying costs between Cost of Goods Sold and operating expenses impacts a company’s financial statements. Accurate inclusion of manufacturing overhead in COGS directly influences gross profit calculation. Gross profit is determined by subtracting COGS from total sales revenue. A precise COGS figure provides a clearer picture of profitability derived from a company’s core production activities.
Non-manufacturing overhead costs, categorized as operating expenses, are deducted after gross profit to determine a company’s operating income. This distinction allows for comprehensive assessment of production efficiency and overall operational management. Accurate cost classification is important for internal decision-making, such as pricing strategies, and for external analysis by investors or lenders who rely on these financial metrics to evaluate a company’s performance and financial health.