Chapter 9 — Cost of goods sold: For Warren the lower the better

On the income statement, right under the line for Total Revenue comes the Cost of Goods Sold, also known as the Cost of Revenue. The cost of goods sold is either the cost of purchasing the goods the company is reselling or the cost of the materials and labor used in manufacturing the products it is selling. “Cost of revenue” is usually used in place of “cost of goods sold” if the company is in the business of providing services rather than products. Essentially they are the same thing—but one is a little more encompassing than the other. We should always investigate exactly what the company is including in its calculation of its cost of sales or cost of revenue. This gives us a good idea of how management is thinking about the business.

A simple example of how a furniture company might calculate its cost of goods number would be: Start with the cost of the company’s furniture inventory at the beginning of the year; add in the cost of adding to the furniture inventory during the year; and then subtract the cash value of the furniture inventory left at the end of the year. Therefore, if a company starts the year with $10 million in inventory, makes $2 million in purchases to add to the inventory, and ends the period with an inventory whose cost value is $7 million, the company’s cost of goods for the period would be $5 million.

Although the cost of goods sold, as a lone number, doesn’t tell us much about whether the company has a durable competitive advantage or not, it is essential in determining the Gross Profit of the business, which is a key number that helps Warren determine whether or not the company has a long-term competitive advantage. We discuss this further in the next chapter.