COGS: Cost of goods sold (formula & definition)

COGS is a commonly used - and often misunderstood - financial term in business. Most companies can easily account for the costs of raw products and materials. 

But you may not be giving the full picture of your COGS - either adding too many items or leaving off crucial ones. Your ability to accurately measure and optimize business expenses may require more nuance.

This article gives you all the keys you need to understand these costs. You will be able to calculate COGS, learn the levers to manage them effectively, and even discover ways to finance them. 

What is COGS (cost of goods sold)?

Simply put, COGS are the costs that go into producing products and services. These are then deducted from revenue to show your gross profit and gross margin.

COGS are often confused with operating expenses (OPEX). OPEX includes a wider range of expenses, beyond purely the costs tied to creating product lines.

As we’ll see, COGS are calculated based on a set period - often a quarter or year. Which means that these costs are only included where they also occur during that period. More on this shortly.  

COGS examples

These are typically limited only to the costs directly incurred in producing goods. COGS may include: 

• Raw materials
• Labor costs directly associated to production
• Factory or laboratory overheads (sometimes including rent)
• Parts and tools used in production

OPEX examples

These are expenses on your balance sheet and detract from your net profit or margin, but are not included in COGS. OPEX may include: 

• Rent and utilities for offices or physical sales space
• Shipping and distribution to get your products to market
• Marketing and advertising, including personnel
• Sales costs, also including personnel
• Corporate staff including accountants, HR, IT, and legal professionals
• Research and development, which is seen as a future investment rather than a cost

COGS in trading companies

In a company that buys items to resell them, COGS are mostly the purchase costs of the goods sold themselves. This accounting item is mostly made up of supplier, transport and storage costs. 

This would apply to many e-commerce businesses, but also marketplaces and supermarkets.

COGS or PRI for production companies

When you’re actually producing the final products themselves, COGS are different. Here you have the costs of parts and labor to actually manufacture your own products. 

Manufacturing companies therefore have direct costs such as raw materials, consumables, energy, direct production labor, logistics, and so on. In the industrial sector, you will often come across the concept of cost price (including some OPEX) versus direct cost price (COGS).

COGS in services companies

Services businesses are a different animal, because you’re not selling such tangible goods. And generally speaking, you don’t need to account for COGS in a services company. COGS typically relies on inventory, and most services companies don’t really have any. 

But you might do this where there is still a real cost (other than labor) to producing your services. This could be the case for software companies, mechanics, painters or builders, and potentially taxi services. These companies need to account for costs like fuel, servers, spare parts, and some wear and tear, even if they’re not a clear part of the service offered. 

How understanding COGS helps you run your business

Knowing and monitoring your direct costs of products sold is extremely useful for managing activities and overall margins, as well as unit margins and selling prices.

Focusing the right people on the right costs

COGS deals solely with direct expenses, without taking account of indirect items that concern the rest of a company’s activity. With this figure, you can easily figure out your gross margin for a certain product line or all products and services overall. 

This is incredibly helpful for product managers and operational staff. They can focus all their energy and attention on creating their products in the most efficient and cost-effective way possible. 

Meanwhile, directors, managers and controllers need to think about the bigger picture, including all other operational expenses. It’s in the company’s best interests to keep all costs down. 

The beauty of calculating COGS correctly is they can become a KPI for people with a more narrow focus. 

Using COGS to calculate a company's unit margins per product and per customer

Companies that calculate the COGS of each product sold can then monitor the margins achieved accurately and regularly. By assigning a direct unit cost to each item offered to customers, they can produce periodic reports analyzing sales from different angles.

This type of reporting can include unit and overall margins for the period:

• By item or family of items
• By customer or type of customer
• By sales rep, market or region

With this detailed data, the sales or finance department can analyse the product and customer mix. Figure out which items bring the best return

Use COGS to set prices

The other obvious advantage of accurately measuring costs and margins is that you can set prices accordingly. This is more insightful and more accurate than simply following the market around you. 

And if the costs to produce a certain item increase, you can increase prices to match. 

How to calculate COGS

As already mentioned, the COGS formula assumes that you have the direct expenses allocated to the products sold by the company, over a certain period. 

COGS formula

The COGS formula is as follows: 

COGS = Beginning Inventory + Purchases in the period − Ending Inventory

Determining total COGS from the income statement

To calculate your company's COGS, use the trial balance rather than the profit and loss account. Here are the items to be included in the calculation of COGS, whatever the activity:

• Purchases of goods
• Purchases of raw materials and consumables, whether or not storable
• Change in inventories (beginning inventory minus ending inventory)
• Transport costs
• Storage costs
• Energy for a manufacturing site
• Staff costs for employees assigned directly to production or order preparation

How cost accounting refines the COGS approach

It’s best to use cost accounting data as a starting point, particularly if you need to split certain items between direct and indirect costs. With a general operating account, you have to break down costs. Sometimes you don't even have enough detail to do this. 

This is the case, for example, for direct labor costs - personnel. Administrative and sales staff are not included in COGS. Their costs come after the gross margin or margin on direct costs and are used to determine operating income.

3.3 - Calculating unit COGS

Once you know the direct cost of sales, you can break it down by product: 

• According to precise unit cost information item by item (raw materials or merchandise in particular)
• According to keys or information provided in the item nomenclature, particularly for an industrial site
• For direct production labor, according to the ranges included in the cost price calculation for each product manufactured (number of hours worked).

How to manage costs of goods sold

COGS affect a company's cost price and direct margin strategy. They are therefore crucial to your profitability. So a system to calculate and monitor COGS is a smart initiative.

This also presupposes regular stocktaking and the development of detailed, relevant cost accounting to analyse the company's costs. Close attention to the cash conversion cycle can also be an essential part of the process, especially if optimising COGS leads to an increase in inventory. 

Reduce COGS to maximise profitability

The more COGS increase, the more the margin on direct costs decreases, and so does profitability. Maximizing financial performance therefore means keeping direct unit costs to a minimum. Every component counts, from raw materials, to ancillary costs, to direct labor.

There are several ways in which companies can work on the impact of COGS on their bottom line. Here are a few ways of reducing purchasing costs from suppliers, even if other items are included in COGS:

• Optimise your sourcing: choose suppliers carefully, and shop around for the best prices.
• Optimise logistics costs like delivery and storage. (Delivery here only applies to the cost of receiving materials, not shipping out your finished products.)
• Carry out a value analysis. Identify opportunities to save on raw materials, packaging or ancillary costs without lowering the quality of the products or services.
• Negotiate bulk purchases to benefit from lower prices.
• Try drop shipping for some activities, where there is no storage or stock management cost associated.

Control working capital in the purchasing process

Buying in bulk has a flow-on effect. Negotiating large purchase quantities inevitably leads to an increase in inventory. You reduce the unit price of products, but, in return, you have to advance more money to suppliers and pay for storage.

And this increases your working capital requirements. It’s worth, therefore, looking closely at inventory financing. This is a loan or line of credit specifically to buy stock for production or to sell on. 

Financing inventory this way keeps your wider working capital available. It’s also a useful way to compartmentalize your investments - these cash injections go directly to the goods sold, so they’re easy to account for. 

Learn more about inventory financing.

COGS is a crucial concept for profitability and cash flow

If you run an SMB, pay close attention to the cost of goods sold. It's a management indicator that has a real impact on profitability, and can help you spot real opportunities to operate more efficiently. 

For more information, read the following guides to small business financing: 

• Supplier relationship management: How to optimise cash flow & maintain relationships
• Cash flow loans: how to get fast funding
• How to optimise your cash conversion cycle (CCC) for growth