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When you run a business that sells any product or service, the cost of goods sold (COGS) is an essential metric. Understanding how it works and how it impacts the financial performance of your business is vital for any business owner or manager.
This guide breaks down what you need to know about COGS, including a cost of goods sold formula to help you make better decisions that improve your long-term business outcomes.
What is cost of goods sold (COGS)?
The cost of goods sold is the total amount your business paid as a cost directly related to the sale of products. Depending on your business, that may include products purchased for resale, raw materials, packaging and direct labour related to producing or selling the goods.
In other words, the materials that go into the product and the labour of making each unit may be included in cost of goods sold. The accounting term for this is direct costs.
But if a cost is general for your business, like rent, a new machine or common marketing costs, it isn’t a cost 100% dedicated to a specific item. Those indirect costs are considered overhead, not the cost of goods sold.
What’s included in cost of goods sold?
Cost of goods sold includes all of the direct costs required to produce, acquire, or prepare an item for sale. These are expenses that can be traced back to a specific product and rise or fall based on how much you sell. Understanding what belongs in COGS helps you calculate it accurately and determine the true profitability of each item you offer.
Here’s what is typically included:
- Raw materials: What is your product made of? Suppose that you make beauty products: Both the bottle components and formula ingredients are raw materials that would fall under COGS. That said, there is a difference between functional and marketing-related packaging. The plastic parts of a bottle containing night cream are considered functional, and you can include them in COGS. But a branded outer box is considered a marketing expense and would be excluded.
- Direct labour costs: Who are the people directly involved in making your product? The wages of team members who work on assembly and manufacturing typically fall under COGS, like production line workers. But the wages of team members involved in functions like distribution, sales or marketing wouldn’t be, as they aren’t directly making the product.
- Manufacturing overhead: While machinery and equipment are considered fixed assets, other factory-related costs flow into COGS. Manufacturing overheads include supplies (such as safety goggles), utilities, equipment maintenance and depreciation tied to production.
- Freight‑in costs: Do you pay to bring in materials or supplies required to make your product? These shipping costs are considered freight-in costs and fall under COGS. On the other hand, freight-out costs are those involved in shipping a finished product out to customers – and they aren’t part of COGS.
- Goods purchased for resale: What if you don’t make your own products? If you purchase items in bulk with the intention of reselling them, like many eCommerce brands do, the cost of goods purchased for resale falls under COGS.
Cost of sales vs. cost of goods sold
Cost of sales and cost of goods sold (COGS) are closely related terms, and many businesses use them interchangeably. The difference usually depends on the type of business you run. COGS refers to the direct costs of producing or purchasing physical goods. Cost of sales is a broader term often used by service-based businesses to describe the direct costs of delivering a service, such as labour or subcontractor fees.
In practice, both represent the direct expenses required to fulfill a sale, and both help you understand the minimum cost of operating your business. The key distinction is that COGS is tied to tangible products, while cost of sales can apply to products, services, or a mix of both.
Why is COGS important?
Cost of goods sold is an important number for business owners and managers to track. Any additional margin goes back to covering overhead and eventually profit. If you don’t know your COGS and break-even point, you don’t know if you’re making or losing money.
COGS is also an important metric on financial statements, as accountants subtract it from a business’s revenues to determine gross profit, which tells you how efficient your company is at managing production costs and also gives investors more insights into your core profitability before variable expenses like marketing or admin are factored in. This information can be used as a benchmark to compare your business to others in the same industry and gauge scalability.
To help you track your profitability, use a profit and loss template. Cost of goods sold is a major input in profit and loss statements. Note that the terms “profit and loss statement” and “income statement” are used interchangeably based on business.
How to calculate cost of goods sold
If you’re wondering how to find cost of goods sold for your business, the standard formula used by accountants and bookkeepers is:
Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold
If you have any manufacturing labour costs, you can include those as well, but that may not apply to all businesses.
Here’s what each part means:
- Beginning inventory: The value of what you already had on your shelves at the start of the period. Example: You start the month with $5,000 worth of inventory.
- Purchases: The value of new inventory you bought during the period. Example: You restock and buy another $3,000 worth of products.
- Ending inventory: The value of what is still left at the end of the period. Example: After counting your stock at month-end, you still have $2,000 worth of goods.
Once you’ve determined which costs roll into your inventory costs, inventory valuation methods like LIFO and FIFO help you assign different values to different batches of products.
LIFO method
LIFO means “Last In, First Out.” This inventory valuation method assumes that the last item purchased or produced is the first item sold. When calculating COGS with LIFO, you’d use this formula first to determine inventory costs:
(Cost of Most Recent Inventory x Quantity Sold From that Batch) + (Cost of Older Inventory x Quantity Sold From that Batch)
For example, let’s say that a business has 100 units purchased at $50 in November and 100 units purchased at $60 in December. If the business resells 120 units by the end of the year, LIFO assumes that the first 100 cost $60 and that the remaining 20 cost $50. The COGS would be (100 x 60) + (20 x 50) = $7,000.
Note that LIFO isn’t accepted by the Canada Revenue Agency (CRA) for income tax purposes as a method of determining cost. This is because if the most recent (and likely the most expensive) stock is recorded as sold first, it results in a higher COGS – which means less gross profit and less taxable income. A business using LIFO in times of inflation could, in theory, still sell older stock that was produced at a lower cost while claiming the higher cost of newer goods.
FIFO method
FIFO means “First In, First Out” and it’s the exact opposite of LIFO. It assumes that the first item purchased or produced is the first item out, which follows the natural flow of inventory, as businesses tend to want to get rid of older stock first. When calculating COGS with FIFO, you’d use this formula first to determine inventory costs:
(Cost of Oldest Inventory x Quantity Sold From that Batch) + (Cost of Next Inventory Batch x Quantity Sold From that Batch)
Unlike the LIFO inventory valuation method, FIFO is permitted by the CRA and is commonly used in Canada.
Cost of goods sold examples
Public companies are required by law to share their cost of goods sold information in their annual reports, so you can always look at cost of goods sold, or cost of sales, for any company listed on the Toronto Stock Exchange (TSX).
Here’s a hypothetical example for a small business, calculated using the standard cost of goods sold formula:
- Beginning Inventory: $15,000
- Purchases: $20,000
- Goods Available for Sale: $35,000
- Less: Ending Inventory: $10,000
- Cost of Goods Sold: $25,000
Here’s another example, calculated using the FIFO formula for inventory:
- Beginning Inventory: $5,000
- Purchases: $10,000
- Goods Available for Sale: $15,000
- Less: Ending Inventory (newest stock): $4,000
- Cost of Goods Sold: $11,000
Learning from cost of goods sold
To get more comfortable with your business’s numbers, think of your business in these ways to better understand your COGS:
- Cost of goods sold is a major contributor to margins: Your business will never make money if cost of goods sold is higher than your product pricing. Always track COGS to help ensure you generate an operating profit.
- Get a fine-tuned understanding of COGS: Don’t just look at the high-level COGS result. Look at every underlying cost for savings opportunities.
- Strategically reduce cost of goods sold: Even small progress on COGS leads to higher profits. For low-margin businesses like restaurants and general retailers, a small difference in COGS can make or break your business.
- Keep a long-term focus: Take care to avoid making cuts that harm your customer experience, product quality, or employee experience, as they could turn around and harm your long-term outlook.
Using cost of goods sold to improve profitability
Large companies hire teams of accountants and financial planning and analysis (FP&A) analysts to review every cost with a fine-tooth comb. While you may want to seek professional support, you can do your own calculations and still find opportunities to improve through your own COGS analysis.
Businesses that use Square have quick access to this information through the Square Dashboard with analytics, inventory, and other reporting tools. When you know what makes up your business costs, you can take steps to keep them under control and work toward your growth and profitability goals. For example, you can:
- Negotiate better pricing with suppliers on your best-selling products.
- Identify products with low margins and make decisions about whether they’re worth selling or not – if you don’t sell enough volume to make up for the low margins, stopping production may be a good decision.
- Reprice items to maintain healthy profit margins. Maybe you decide to increase the price of an item because the costs of raw materials have increased. Perhaps you lower the price of another because your margin comfortably allows for it and you want to sell more units.
Whether you’re trying to create or maintain a business to support your family or set yourself up for retirement, COGS is almost certainly part of the formula. With a good understanding of how it works, you are in better control of your company’s destiny.
Costs of goods sold FAQs
What costs are included in cost of goods sold?
COGS includes all the costs directly associated with making or acquiring the products you sell. It can include raw materials, direct labour costs, factory overheads such as utilities, rent, maintenance, depreciation and manufacturing supplies, freight-in costs and goods purchased for resale.
If you’re unsure about whether a cost falls under COGS, ask yourself: ‘Does this cost only exist because I’m making or acquiring a product to sell?’ If the answer is yes, it might fall under COGS.
How does COGS affect my business’s profitability?
Yes, COGS affects your gross profit, which is what’s left after you’ve covered the costs of making your products. The higher your COGS, the lower your gross profit, which gives you less bandwidth to pay for overhead expenses such as marketing or admin while still making a profit. Understanding COGS can help you make smarter decisions, like choosing prices that help you maintain healthy margins.
Are salaries included in COGS?
Some salaries are included in COGS, but only for employees that are directly involved in the production of your product, such as line workers. The salaries of team members who work in supporting roles, like sales reps or HR coordinators, don’t fall under COGS and are considered operating expenses.
How does inventory impact COGS?
Inventory is central to the COGS formula. Beginning inventory and purchases show what you had available to sell, while ending inventory shows what’s left over. The difference represents the cost of the products actually sold during the period. Inaccurate inventory counts lead to inaccurate COGS, which can distort your gross profit and make it harder to understand how your business is performing. Inventory methods like FIFO also affect how costs are assigned to COGS.
How often should I calculate cost of goods sold?
Since COGS is included in a business’s profit and loss (P&L) statement, you need to calculate it at least once a year as part of your annual tax filing requirements. But there are benefits to tracking COGS more often, like monthly or quarterly, since it can help you monitor profitability and make adjustments as necessary.
