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Cost of Goods Sold (COGS) vs. Expense

Instructor: Yuanxin (Amy) Yang Alcocer

Amy has a master's degree in secondary education and has taught math at a public charter high school.

Read this lesson to learn why the cost of goods sold and expenses are listed on separate lines on financial business documents. You'll also learn that there is a tax advantage to doing things this way.

Cost of Goods Sold

Imagine that you are the owner of a business that sells electronics. You make electronic gadgets that people love such as a watch that tells you when it's going to rain so you'll always know when you need to bring an umbrella. You make a lot of money selling your electronics. But you also have to spend a lot to make your products. All of this is recorded on your financial statements that you keep for your quarterly earnings statements to your stockholders, as well as for your annual taxes. On your financial statements, you notice that your cost of goods sold is a separate line from your expenses line. You've always wondered by this is so. Well, let's take a look.

Your cost of goods sold includes only the cost it took to make the products that sold for the year. This includes whatever wages went towards the making of your products and the cost of the materials that go into your products. If you purchase your products for resale from a manufacturer, your cost of goods sold is your wholesale cost for the products that sold in the year.

For your electronics business, your cost of goods sold includes the wages to the employees that handle the manufacturing of the product along with the purchasing costs of the materials that go into the making of your electronics such as plastics, metals, batteries, gears, and wires.

Expense

Your expenses includes the money you spend running your business. This includes your rent, advertising, office supplies and whatever else you need to spend money on to keep your business running.

For your electronics business, your expenses include things like your rent, the cost to provide health insurance to your employees, electricity to power all your electronics, and the cost of all the ink and paper required to print all the documentation for your products.

Similarity

Your cost of goods sold and your expenses have one big thing in common: your cost of goods sold is actually an expense item. This similarity is what had you wondering in the first place. If your cost of goods sold is an expense item, then why does it have its own line?

The answer is actually a tax answer. Your cost of goods sold is a separate line item from your expenses because the IRS allows you to deduct your cost of goods sold from your taxable earnings thus reducing your overall tax obligation.

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