What it means
When a company sells a product, the sale earns revenue, and COGS records the direct cost of producing that product. Subtracting COGS from revenue gives gross profit, the money left to pay for everything else, such as salaries, rent and advertising.
If COGS is too high compared with sales, the business is struggling to make money from its core activity. What counts as COGS depends on the type of business.
A manufacturer includes raw materials, factory wages and factory overheads. A retailer includes the purchase price of the stock it sold plus freight-in, while a service business may count the direct labour used to deliver the service.
An important point is that COGS only covers goods that were sold, not everything that was bought or made. Items still sitting in the warehouse are inventory, which is an asset on the balance sheet.
That is why the standard calculation starts with opening inventory and ends with closing inventory. The inventory valuation method changes the number.
First In First Out (FIFO) assumes the oldest stock is sold first, while weighted average spreads costs evenly across all units. When prices are rising, FIFO usually gives a lower COGS and a higher profit than other methods, so managers should know which method their accounts use.
Business leaders watch COGS closely because it drives pricing and margins. A small change in supplier prices can reduce gross profit significantly if selling prices cannot be raised.
Comparing COGS as a percentage of revenue over time, and against competitors, is a quick health check on efficiency. COGS also feeds directly into inventory planning and cash flow.
A business that builds stock early pays for materials before it books any COGS, so cash leaves the bank well before profit shows it. Finance teams track both to avoid being surprised by a healthy profit figure alongside a tight cash balance.
In practice
Real-world examples.
Example
A furniture maker sells 200 tables in a quarter. The wood, hardware and workshop wages for those tables come to $60,000, which is recorded as COGS, while the sales team's salaries are not included. Sales commissions and delivery to customers sit elsewhere in the income statement.
Example
An online electronics shop buys phone cases for $4 each and sells 50,000 of them. Its COGS is 50,000 x 4 = $200,000, plus the inbound shipping paid to bring the stock into the warehouse. It also records the card fees that apply to cost of sales, which keeps its margin reporting honest.
Example
A software company counts hosting costs and customer support staff directly serving paying clients as its COGS. Its gross margin is therefore lower than that of a pure licence business, and investors compare it with other software companies on that basis. Investors compare its gross margin with those of similar software firms to judge how efficient it is.
Formula
Calculation
COGS = opening inventory + purchases during the period - closing inventory
Gross profit = revenue - COGS
Suppose a clothing retailer starts the year with $120,000 of inventory, buys $480,000 of stock during the year, and finishes with $150,000 of inventory. COGS = 120,000 + 480,000 - 150,000 = $450,000. If revenue for the year was $900,000, gross profit = 900,000 - 450,000 = $450,000. The gross margin is 450,000 / 900,000 = 50%.Case study
Seen in the real world.
Brookfield Bakery Supplies is an illustrative, fictional wholesaler of baking ingredients. Its revenue grew by 15% in a year, but profit fell, and the owner could not understand why.
The finance manager analysed COGS and found it had risen from 62% of revenue to 68%. A supplier had increased flour prices, and the company had not passed the increase on to customers.
By raising selling prices by 6% and renegotiating with two suppliers, the company brought COGS back to 63% of revenue. The illustrative lesson is that growing sales without watching COGS can quietly erode profit. It reviewed supplier prices monthly afterwards, so any cost rise was spotted before it hurt profit.
Watch out
Common mistakes.
- Including selling, marketing or administrative costs in COGS, when it should only hold costs directly tied to the goods sold.
- Counting everything purchased during the year as COGS, and forgetting to adjust for closing inventory.
- Comparing COGS between companies without checking whether they value inventory using the same method.
Questions
People also ask.
Is COGS the same as operating expenses?
No, COGS is the direct cost of the goods sold, while operating expenses cover the general costs of running the business.
Do service businesses have COGS?
Many do, and they usually label it cost of revenue or cost of services, covering the direct labour and delivery costs.
Why does COGS matter for tax?
It reduces taxable profit, so correct and consistent recording affects how much tax a business pays.
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