What are the direct costs or Costs of Goods Sold? Let's understand with an example

Cost of goods sold or cost of service is the second most important thing to look at in an income statement - let us see why and how?

Apr 27, 2023
What are the direct costs or Costs of Goods Sold? Let's understand with an example
I am Furqan Punjani and I have been doing financial analysis work for 15 years now! This short newsletter - Statement Secrets is to help investors become better at looking at financial statements in an easy and fun way.
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Last time we discussed revenues and revenue growth in detail.
Recap: If revenue is growing, it’s a good thing, if it’s falling it’s not an ideal scenario. In two ways revenue go up, either through price or volume.
But think about this: to sell something (make revenue) you need to first make something right? And that thing will have some cost to make!

What is the cost of goods sold?

Every cost that a company or a startup has to incur to make the goods, comes under the Cost of Goods Sold.
When we combine all these costs, we call them the cost of goods sold (I have explained this in detail below).
This is how it looks like in the financial statement ⬇️ This is the next item after revenue/sales or net sales.
notion image
See there are no details about the cost in the image above. It is just showing ONE number.
Companies disclose details way inside the financial statements.
This is how it looks ⬇️
notion image
Let me take a little detour here to explain how can you get details of cost in a financial statement before I move to explain 3 important concepts that you should know about the cost of goods sold.
Can you see a number (31) just before the actual cost? This is an index number telling you which sub-heading will you find the breakup of this!
notion image
You have to keep going inside the book until you find this number on the left side! Volla - here is the breakup.

Concept 1: Only what’s required to make the product or a service

Let us take a practical example to understand this.
There is a steel company that makes rebars (sarya). What does it need to make the final product?
  • Steel scrap
  • Electricity to heat the steel scrap and melt it
  • A machine that rolls this melted steel into the final product
But to have the machine, they need to first buy it, so in this example, they took the debt from a bank.
Question: What will come under this cost of goods for this simple example?
  1. The cost of raw materials of course! This is directly required to make the final product.
  1. If there is no electricity then the raw material can’t be melted, so again this is a direct cost.
  1. They are using the machine which means the machine is losing its value. So they will have to put aside some money for the time when they have to buy a new machine (called depreciation) - so yes!
  1. They need labour to operate these machines - so yes that will also go into the cost of goods sold
  1. Once the final product is made and is at the factory, we need to deliver it to our warehouse also, so yes that is also a cost!
That is all!
The company will add up all the costs like these and make up one number called the cost of goods sold.
But what about the interest we will have to pay to the bank against the loan we took?
That doesn’t come here!
What if they didn’t have to take the debt? What if they had money of their own? Since this is subjective and every company may have different debt levels, these costs come later.
We are just concerned about the direct costs that go into making steel (for example) and nothing else here.

Concept 2: What does inventory have to do with cost?

If you are paying attention, you might have seen some other things that are coming under cost but I haven’t discussed them.
This ⬇️
notion image
What is this?
Think like this.
This is not the first year the company has started making steel. What if they had made re-bars last year which they couldn’t sell?
They would sell them first before making new re-bars to sell right?
This box is showing that.
It’s telling that they sold the inventory that was available in the warehouse. That also had a cost. And they have to include that cost in this year’s cost of goods sold.

Concept 3: Mixed cost

The management of this steel company will be very upset with this email. I didn’t add their cost to the cost of goods. Shouldn’t the CEO, CFO and other people working in the head office be part of this direct cost?
Only the labour that’s directly involved, working at the plant would come here.
So all the other costs like electricity, salaries, cars, and perks given to people working in the head office wouldn’t be included here.
They are costs for sure, just that it will be marked somewhere else.
See, we want to know exactly the cost that goes into making the final product so that we can compare this cost between competitors to see who has the lowest cost and why.
This is all you should know about the Cost of goods sold as a reader of the financial statement, student or investor.
All other details and nitty-gritty are for accountants. You don’t have to worry about them.
I have done a small analysis as to what’s happening with the cost of this company but since I promised to keep the email short, I have posted it on the website along with this full article.

Cost Analysis of this Company

There is a trick to analyzing any financial statement. You only need to follow big meaningful numbers. Small numbers don't matter that much. Let me explain my process.
  • First up, I am seeing that the total cost has gone up. The total cost of goods sold has gone up to Rs51bn i.e. 50%. This is huge but unsurprising since they import raw materials and the dollar has depreciated quite a lot! Now I want to see the details.
  • The biggest jump that I see is coming from the cost of billet that they have manufactured themselves. Breakup ⬇️
notion image
  • What is the biggest number you see here? Purchases. This is the imported raw material. It has gone up from Rs24bn to Rs42.6bn i.e. up 78%
  • The next big thing that I see is Fuel and Power. It has also gone up but by a lesser percentage i.e. 34%.
  • Stores and spares have also gone up. Think of them as spare parts for machines. Since they are also imported they have gone up 57%.
  • All the other things are small and hence not that meaningful.

My Takeaway for Future Analysis

  • It looks like most of the cost is directly dependent upon rupee depreciation and international scrap steel prices (I will not go into details about international scrap prices, we will cover them in detail when we reach the valuation part).
  • But any investor should keep an eye on the rupee's depreciation. It impacts the company the most.
  • The other thing that investors should follow is fuel and power costs since it's a big number and it will follow the rupee depreciation sooner or later.
  • Costs have gone up but they have also increased their sales (recall the last note or click here to re-read the volume vs price growth part). This means that they are able to increase their product prices for now.
We will combine the two (sales vs cost) in the next section when we look at the gross margins.

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