How does the cost of goods sold (COGS) affect financial statements?

The cost of goods sold (COGS) plays a crucial role in determining gross profit, which is calculated by subtracting COGS from total revenue on the income statement. This measurement is essential because it reflects the direct costs attributable to the production of the goods sold by a company during a specific period. An increase in COGS will decrease gross profit, and consequently, if all other expenses remain constant, it will also reduce net income.

Net income, derived from the bottom line of the income statement, is the ultimate measure of profitability for a company. Therefore, COGS directly influences both gross profit and net income, making it a vital component of financial performance assessment.

While it does affect the balance sheet indirectly—through retained earnings that accumulate from net income—it primarily impacts the income statement, which reflects operational performance over a given timeframe. This interplay highlights the significance of COGS in evaluating a company's financial health and operational efficiency.