What is Cost of Goods (COGS)? The meaning of cost of goods is the direct cost of producing a good. Cost of goods is a factor in determining the gross profits of a company. And, by extension, the cost of goods also determines gross profits. The cost of goods sold combines production costs and other costs directly associated with producing a product.
In the case of cannabis companies, this could include the cost of seeds, nutrients, water, electricity, packaging material, delivery costs, labor, rent, and any other costs directly associated with the actual production of any product.
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Where to find the Cost of Goods
In financial statements, the cost of goods is listed just below revenue in the top of the financial statement. The cost of goods is deducted from top-line revenue and the remainder is gross profits. The remainder can then be divided by top-line revenue to determine gross margins.
Because Cost of Goods Sold is a business expense this is recorded in the financial statements. COGS is most often found in the second line of the financial statements, just below revenue, as a line item in the financial statements. COGS are deducted from revenue to show gross profits.
The Importance of Cost of Goods
Understanding the cost of goods is important. If a cannabis company’s cost of goods sold increases relative to revenue, this means that gross margins will decline, which could mean a shift lower in both EBITDA & net earnings.
Also, if a company has costs that are high relative to overall revenues, then it will be difficult for a company to achieve profitability. A cannabis company would need to scale up considerably in order to achieve economies of scale in order to become profitable.
Therefore, keeping track of gross margins is key to analyzing the potential profitability of a cannabis company. Should there be increases in revenue, but there are outsized increases in the cost of goods, marginal profits will decline.
Fixed Costs & variable Costs
When you see COGS, or cost of goods sold, there will be two different types of costs incurred within these costs. These costs can be broken down into two separate groups:
- Fixed Costs
- Variable Costs
I will break down each expense.
What are fixed costs
Fixed costs are costs that no matter what the production level, these costs are incurred on a regular basis. A good example of fixed costs is the rent for a processing facility for cannabis. No matter what the production level, the rent will need to be paid. But, understanding this one concept will help you analyze a company that is growing and still in the early stages.
For example, assume a company rents 10,000 sq. ft. of a warehouse type building that is rented at $1.00 per foot per month. That is $10,000 per month. If a cannabis company only processes 1 gram of cannabis and sells that for $5.00 per gram, the business will still need to pay the $10,000 in rent.
But, what if that same cannabis company processed 10,000 grams, or 10 kg. of cannabis in the same facility? This would mean that the cannabis company processed 10,00 grams and sole them for $50,000 during a month. Despite the increased processing, the fixed cost of $10,000 per month for rent is set.
From the perspective of rent, a fixed cost, this cannabis company would be profitable.
What are variable costs?
The other type of cost is a variable cost, which these costs are not fixed, they vary depending upon production. Some examples of variable costs for a cannabis company would be: labor, packaging, electricity for the grow lights, water, nutrients, shipping costs, etc.
In the above example, the costs for producing one product may be minimal. But, when spread out over just one product, this would represent a very large percentage of cost relative to the revenue generated by just one product.
If the same cannabis company were to begin processing larger and larger quantities, costs would be spread out over more and more product. The electricity for one grow light may power enough to work for 10 cannabis plants. But, if the company is only producing one plant, this would not be a method of maximizing the potential of that input variable.
It is for this reason that a company will achieve far greater margins relative to revenue with economies of scale by scaling up production to much bigger levels.
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What is not found in the Cost of Goods
Certain costs are not associated with the cost of goods. Revenue can be thought of as being derived from these sections:
- Core-Business Revenue
- Non-Core Revenue
- Non-Core Income
Costs directly attributed to operating costs would be a core-business expense. But, operating costs are not directly attributed to the cost of goods. Instead, operating costs are those costs involved in running the cannabis business & sales of the cannabis business, but not producing the products.
In the financial statements, you will find three core-business costs in operating costs:
- Sales, General, & Administrative (SG&A)
- Depreciation & Amortization
- Research & Development
Another cost not associated with producing products would be financing costs. Financing costs are typically stated in the financial statements under “Continuing Costs & Profits” and, they are the final costs listed.
Continuing costs are usually costs are also costs associated with non-core business costs, unusual costs, and costs tied to stock options, warrants, and other costs outside of usual business functions.
Accounting Standards & COGS
The value of COGS may differ based on the methodology of accounting practice used by any particular company.
This is important as some cannabis stocks switch toward Generally Accepted Accounting Practices (GAAP) away from IFRS accounting. Most US firms, publicly traded on US exchanges use GAAP. However, and especially in some cannabis stocks, GAAP is not necessarily the norm.
Examples of Cost of Goods (COGS)
In the below examples, you can see the financial statements for InterCure Limited, an international cannabis company:
InterCure INCR Stock Financial Data
In the above example, for December 2021, InterCure Limited printed $25.7M in total revenue, with Cost of Goods (COGS) of $13.9M. This left InterCure with gross profits of $11.8M which is 45.9% gross margins.
Understanding top-line revenue, cost of goods, gross profits, and gross margins are an essential step in understanding how to read financial statements.