What it means
A business that sells goods incurs two kinds of cost: the cost of the goods themselves and the cost of running the business that sells them. Cost of goods sold is the first.
Revenue less COGS is gross profit, the money left after paying for what was sold, from which everything else (rent, salaries, marketing, administration, interest, tax) must be paid. The gross margin (gross profit as a percentage of revenue) is the first indicator of a business's economics: what it earns on each sale before the cost of its own structure.
What goes into COGS depends on the business. A retailer's COGS is the invoice cost of the goods sold, plus freight in, import duties and handling to get them to the shelf, less supplier rebates and discounts.
A manufacturer's COGS is the production cost of the units sold: direct materials, direct labour and manufacturing overhead (factory rent, depreciation, supervision, energy, indirect materials), absorbed into inventory as the goods are made and released to COGS as they are sold. A service business's cost of sales is the direct cost of delivering the service: the consultants' salaries for a consultancy, the drivers and fuel for a haulier, the hosting and support staff for a software company.
What stays out: selling costs (sales staff, marketing, distribution to customers, though some businesses include outbound freight), administration, research and development (usually), and finance costs. The boundary is not fixed by standards in detail, and companies draw it differently, which affects gross margin comparisons.
One retailer includes store occupancy in COGS and reports a 30% gross margin; another excludes it and reports 40%; their operating margins may be identical. Analysts standardise before comparing, and companies disclose what they include.
The computation runs through inventory. Goods bought or made in a period are not all sold in it; some are in inventory at the end, and some sold in the period were in inventory at the start.
COGS for the period = opening inventory + purchases (or cost of goods manufactured) minus closing inventory. Every element of inventory accounting therefore affects COGS: the cost flow assumption (FIFO, LIFO, average) determines which costs are released; overhead absorption rates determine how much production cost is in each unit; write-downs to net realisable value hit COGS; physical count adjustments hit COGS; and errors in closing inventory flow straight into COGS and profit (an overstated closing inventory understates COGS and overstates profit by the same amount, and reverses next year).
The trend of COGS as a percentage of revenue is watched closely. A rising percentage means falling gross margin: input prices rising faster than selling prices, a mix shift to lower-margin products, discounting, inefficiency or waste in production, or a change in what is included.
A falling percentage means the reverse. Because COGS is the largest cost, a change of a point in the percentage often matters more than any operating expense line.
For tax, COGS is deductible as the goods are sold, and the inventory rules (including uniform capitalisation requirements in some jurisdictions that push more overhead into inventory) govern the timing. For management, COGS analysed by product, customer and channel is the basis of margin analysis; and the components of COGS (materials, labour, overhead, freight) are where cost reduction programmes in product businesses begin.
In practice
Real-world examples.
Example
A supermarket's COGS is 75% of revenue, and a 0.5-point improvement through better supplier terms is worth more than closing every unprofitable store.
Example
A car manufacturer's COGS includes warranty provisions on the vehicles sold, since the obligation arises from the sale.
Example
A consultancy reports cost of sales as the salaries and expenses of its billable staff, giving a gross margin of 45% that falls when utilisation drops.
Think of it
“COGS is like the ingredients cost for a restaurant. It's what you directly spend to make the dishes you sell, not the rent or advertising costs.
Formula
Calculation
Cost of Goods Sold = Opening inventory + Purchases (or Cost of goods manufactured) minus Closing inventory
Cost of Goods Manufactured = Direct materials used + Direct labour + Manufacturing overhead + Opening WIP minus Closing WIP
Gross Profit = Revenue minus COGS; Gross Margin = Gross profit / Revenue x 100%
Effect of an inventory error: Closing inventory overstated by X → COGS understated by X → Profit overstated by X (and the reverse next period)
Worked example 1, a distributor. A building supplies distributor's year:
- Opening inventory: $2,400,000
- Purchases at invoice: $18,600,000
- Inbound freight and handling: $740,000
- Supplier rebates earned: $310,000 (a reduction of purchase cost)
- Closing inventory (at cost, after a $60,000 write-down of damaged stock): $2,750,000
- Revenue: $26,000,000
COGS = $2,400,000 + $18,600,000 + $740,000 minus $310,000 minus $2,750,000 = $18,680,000
Gross profit = $26,000,000 minus $18,680,000 = $7,320,000; gross margin 28.2%.
The $60,000 write-down is within COGS (closing inventory is lower by $60,000, so COGS is higher). The rebates reduce COGS; had they been credited to other income instead, gross margin would have been 27.0% and operating profit unchanged, which is why the policy is disclosed.
Prior year: gross margin 30.1%. The 1.9-point decline is analysed: supplier price increases of 6% against selling price increases of 4% (1.4 points); a mix shift towards lower-margin commodity lines (0.4 points); freight cost increase (0.3 points); offset by higher rebates (0.2 points). On $26,000,000 of revenue, 1.9 points is $494,000 of gross profit, more than the year's entire increase in operating expenses.
Worked example 2, a manufacturer. A furniture maker's year:
- Direct materials used: opening raw materials $400,000 + purchases $3,100,000 minus closing raw materials $450,000 = $3,050,000
- Direct labour: $1,900,000
- Manufacturing overhead: factory rent $360,000, depreciation $420,000, supervision $310,000, energy $180,000, indirect materials and maintenance $230,000 = $1,500,000
- Total manufacturing cost: $6,450,000
- Opening work in progress $280,000; closing WIP $320,000: cost of goods manufactured = $6,450,000 + $280,000 minus $320,000 = $6,410,000
- Opening finished goods $900,000; closing finished goods $1,050,000
- COGS = $900,000 + $6,410,000 minus $1,050,000 = $6,260,000
- Revenue $9,800,000; gross profit $3,540,000; gross margin 36.1%
Inventory error illustration: the closing finished goods count missed a container of 200 tables at a cost of $150,000, so closing inventory was understated at $1,050,000 rather than $1,200,000. COGS was overstated by $150,000, gross margin understated by 1.5 points, and profit understated by $150,000. When the error is found the following year, that year's opening inventory is understated too, so its COGS is understated by $150,000 and its profit overstated by the same: the two years net to zero but each is wrong. The correction, if the error is material, restates the first year.
Worked example 3, a service business. A software company reports revenue of $40,000,000 and cost of sales of $12,000,000: hosting $4,500,000, customer support staff $5,000,000, third-party software royalties $1,500,000, implementation contractors $1,000,000. Gross margin 70%. Research and development ($9,000,000), sales and marketing ($11,000,000) and administration ($4,000,000) are below gross profit. A competitor includes its implementation team and part of its R&D in cost of sales and reports 58%; the two are comparable only after reclassification, and the analyst who compares 70% with 58% without adjustment reaches the wrong conclusion about which company has the better product economics.Case study
Seen in the real world.
A listed clothing retailer had reported a gross margin between 58% and 60% for six years, well above its peers' 50% to 54%, and its premium valuation rested on it. A short-seller's analysis found the reason: the retailer classified store occupancy costs, distribution centre costs and inbound logistics as operating expenses, while every peer included them in cost of sales. Restated on the peers' basis, the retailer's gross margin was 51%, in the middle of the range, and its operating margin, which the classification did not affect, had been below the peer median for three years.
The retailer's disclosures had been accurate throughout; its policy was stated in the notes. The analysis nonetheless reset the market's view, and the share price fell 20% as the premium unwound.
The retailer's chief financial officer subsequently reclassified the costs into cost of sales, restating comparatives, and explained that the company had never intended the comparison to mislead but had never volunteered the reconciliation either. The episode is used in analyst training as the standard example of why gross margins are compared only after the cost of sales boundary has been checked.
Watch out
Common mistakes.
- Comparing gross margins across companies without checking what each includes in cost of sales, which can differ by ten points for identical businesses.
- Treating COGS as a purchases figure. It is the cost of what was sold, computed through inventory, and errors in inventory flow directly into it.
- Managing operating expenses in detail while the COGS percentage drifts, when a point of gross margin usually outweighs the whole of any operating expense line.
Questions
People also ask.
What is the difference between COGS and operating expenses?
COGS is the direct cost of the goods or services sold; operating expenses are the costs of running the business (selling, administration, R&D). Revenue less COGS is gross profit; less operating expenses is operating profit.
Is COGS the same as purchases?
No. Purchases are what was bought in the period; COGS is the cost of what was sold, which equals opening inventory plus purchases minus closing inventory.
Does a service business have COGS?
Yes, usually called cost of sales or cost of services: the direct costs of delivering the service, such as billable staff, subcontractors, hosting and materials. The boundary with operating expenses is a matter of policy and should be disclosed.
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