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Wondering what is COGS and how to calculate it? Cost of Goods Sold (COGS) is a core concept in small business accounting and if you’re running a product-based or service-driven business, it’s one number you can’t afford to ignore.
COGS shows up right near the top of your income statement for a reason. It reflects the direct costs tied to producing what you sell like materials, labour, and packaging. Knowing how to calculate COGS helps you set the right prices, stay profitable, and understand your gross margin at a glance.
In this guide, we’ll break down what COGS includes, how it’s calculated, and how you can use it to run a leaner, smarter business.
What is COGS?
Cost of Goods Sold (COGS) refers to the direct costs of producing the goods or services your business sells. It includes materials, production labour, and related overheads.
In simple terms:
Sales revenue – COGS = Gross profit
COGS is considered a business expense and impacts your profit. The higher your COGS, the lower your profit margin. This means less net profit retained in the business, which can ultimately reduce your business equity.
For example, if you spend $10 to produce a product (including materials and direct overheads) and sell it for $15, your gross profit is $5.
COGS differs from operating expenses like rent, admin, or marketing; it only captures costs directly linked to production. In retail, it’s the price paid for inventory. In manufacturing, it includes raw materials and labour. Ecommerce businesses might also include freight or platform fees when directly tied to product sales.
Tracking COGS accurately is essential for setting prices, managing margins, and understanding business performance. A reliable accounting platform makes that job easier.
COGS vs. Cost of Sales: What’s the difference
Both terms are similar, but your business model determines which one applies.
If you sell physical products, like apparel, materials, or food, then you calculate Cost of Goods Sold (COGS).
On the contrary, if you offer services, like consulting, accounting, or legal work; you use Cost of Sales instead.
The calculation principles are similar: both reflect the direct costs of delivering what you sell, and both need to be reported on your financial statements. It’s just the label that changes based on what you offer.
How to calculate COGS for your business
Calculating COGS isn’t just about tallying up what you spent. It’s a methodical accounting process that gives insight into the true cost of delivering your product or service during a set financial period.
The standard formula of calculating COGS is:
COGS = beginning Inventory + purchases during the period – ending inventory
What does this mean exactly?
Suppose, you have defined a financial period of 12 months. Your beginning inventory will be stock in hand from the previous period. All the purchases during the period will be stock you bought in those 12 months. And ending inventory is what you have left for the next period.
Let’s say you’re running a retail business and you’re calculating COGS for FY2024–25. You have:
- Opening stock on 1 July 2024: $2,000
- Inventory purchased between July and June: $5,000
- Closing stock on 30 June 2025: $1,000
Your COGS = $2,000 + $5,000 – $1,000 = $6,000
Why it matters:
Once you know your COGS, you can calculate gross profit:
Gross Profit = Sales Revenue – COGS
For example, if your annual sales were $15,000 and your COGS is $6,000, your gross profit is $9,000.
Where it shows up:
COGS is one of the first line items on your profit and loss statement. It directly affects your gross profit margin, pricing strategy, and how profitable your business looks on paper.
Keeping accurate COGS records not only helps with tax reporting but also supports better decision-making around pricing, inventory control, and cash flow planning.
P.S.: If you suspect your cost records are inconsistent or you’re seeing unexplained margin dips, it may be worth going deeper. Forensic accounting can help uncover errors or misreporting that affect your COGS accuracy.
3 core components that make up COGS
Cost of Goods Sold (COGS) includes all the direct costs involved in producing or delivering what you sell. It’s made of following 3 components:
- Cost of direct material: This is the base or wholesale cost of the products or materials; used to either sell or manufacture a product.
- Cost of direct labour: It includes wages paid to workers directly involved in making the product.
- Cost of direct overheads: These are operational expenses linked directly to the production process, like factory utilities or equipment maintenance.
What are the COGS accounting methods
Choosing the right inventory valuation method is key to calculating your cost of goods sold accurately. Here are some of the most commonly used methods:
First in, first out (FIFO):
The FIFO method focuses on selling the oldest inventory first. As prices increase over time, the least expensive products get sold first. This leads to a lower initial COGS.
Weighted average cost (WAC):
The WAC method calculates weighted average cost based on inventory spending and COGS.
How to calculate it:
Total cost of goods purchased/ total units in inventory = average cost per unit.
Special consideration method:
This approach tracks ending inventory and COGS by analyzing the exact cost of each item sold. It’s precise but only practical when you sell high-value, unique products, like vehicles, designer jewellery, or real estate.
P.S. : Your tax accountant should advise you on the valuation method that best suits your business. While COGS focuses on direct production costs, it’s also important to keep track of other end-of-period expenses, like unpaid wages or supplier invoices, that haven’t been paid yet. These accrued expenses can impact how you report your financials alongside COGS, especially when using the accrual accounting method. Here’s what accrued expenses are and how they work.
Why COGS is important for your business
COGS isn’t just an accounting figure, it’s a key part of running a financially healthy business. Here’s why it matters:
1. Better understanding of your financial health
Your gross profit margin starts with COGS. If you don’t know what it costs to produce or deliver your goods, you’re flying blind. Accurate COGS helps you measure profitability and track performance over time.
2. Make smarter business decisions
A rising COGS can signal inefficiencies. Whether it’s supplier prices creeping up or operational waste, knowing your COGS gives you a chance to act, cut costs, renegotiate contracts, or adjust pricing before profits take a hit.
3. Price your products accurately
If your COGS is too high, even solid revenue won’t translate into real profit. Tracking it lets you spot margin squeeze early and adjust prices to stay competitive and profitable.
4. Attract investment opportunities
Investors and lenders want to see strong margins and well-managed costs. A clear handle on your COGS shows them you understand your unit economics, making your business a safer and smarter bet.
P.S.: Investors today care about more than just profit, they’re also looking at how responsibly a business operates.
Want to know why that matters? Check out our guide on ESG investing and what it means for your business.
Need help calculating your COGS accurately?
Sleek’s accountants help you track direct costs, choose the right accounting method, and set prices that protect your profit margins. Schedule a consultation today and get expert support tailored to your business model.
Conclusion
Understanding what is COGS and how to manage it can make all the difference to your business’s profitability. From setting the right prices to optimising inventory and reducing waste, tracking your cost of goods sold gives you the financial visibility needed to make smarter, more strategic decisions. It’s not just a number on your income statement, it’s a key lever for boosting margins and building long-term, sustainable growth. Keep it accurate, keep it updated, and you’ll stay firmly in control of your bottom line.
FAQs on what is COGS
If your business earns income from both product sales and service delivery, you must allocate direct costs carefully. Product-related costs go into COGS, while service-related costs are typically treated as operating expenses. A clear cost allocation model ensures accurate gross margin reporting and avoids compliance issues.
Significantly. FIFO vs Weighted Average Cost can shift gross margins, especially in inflationary environments. This affects key metrics like gross profit ratio, EBITDA, and even business valuation. Investors and acquirers often scrutinise your inventory valuation method as part of due diligence, so consistency and transparency are key.
A “good” COGS percentage varies widely. For example, retailers often aim for 60–70%, while service-based businesses may see far lower rates. Compare against your industry benchmarks and watch trends over time to identify margin pressure or pricing opportunities.
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