What Is COGS and Why Is It Key to Understanding Your Business's Profitability?

When it comes to evaluating a company’s financial health, there’s one metric that should never be overlooked: COGS. Although it may sound technical, this concept—short for Cost of Goods Sold—is essential to understanding how much it really costs to sell a product and, therefore, how much profit your business is actually generating.

In this article, we’ll explain what COGS means, how it’s calculated, how it differs from other types of expenses, and how you can use it to make smarter strategic decisions—especially if you operate or plan to operate a business in the United States.

What Is COGS?

COGS refers to the direct cost associated with the production or acquisition of goods that a business sells. In other words, it includes everything needed to get a product ready for sale—such as raw materials, direct labor, and manufacturing costs. It does not include indirect expenses like advertising, administrative salaries, or office rent.

This metric appears on your income statement and is subtracted from gross revenue to calculate gross profit. Proper COGS management helps optimize margins and assess whether your business model is truly sustainable.

What Does COGS Include?

The specific items included in COGS depend on the nature of the business, but generally, it covers:

• Raw materials or goods purchased for resale
• Direct production costs (e.g., factory labor)
• Shipping costs related to acquiring inventory
• Storage costs directly tied to the products
• Packaging and labeling of finished goods

In the case of SaaS or service-based companies, traditional COGS deductions don’t apply in the same way as they do for retailers. However, there is a similar concept called Cost of Services Sold (COSS).

What Does COGS Not Include?

COGS does not include:

• Marketing expenses
• Administrative salaries
• Professional services (consulting, accounting, etc.)
• Rent or general overhead not related to production
• Financial costs and interest payments

These are categorized as operating expenses and are analyzed separately.

How to Calculate COGS

The general formula to calculate COGS is simple:

COGS = Beginning Inventory + Purchases During the Period − Ending Inventory

Practical Example:

Let’s say you start the month with $5,000 in inventory, purchase $3,000 worth of products, and end the month with $4,000 in inventory:

COGS = 5,000 + 3,000 − 4,000 = $4,000

This means your business sold $4,000 worth of goods that month. If your sales revenue was $10,000, your gross profit would be $6,000.

Accounting Methods for Calculating COGS

Depending on your accounting method, COGS can vary. The main approaches are:

1. FIFO (First In, First Out)

Assumes the oldest inventory items are sold first. Often used in inflationary contexts to show higher profits.

2. LIFO (Last In, First Out)

Assumes the newest items are sold first. Common in the U.S., but not allowed in many other countries.

3. Weighted Average Cost

Calculates the average cost of inventory, smoothing out price fluctuations.

Why Is Tracking COGS So Important?

• Gross Margin Insight: COGS shows you how much you truly earn per product sold.
• Supplier Evaluation: An increase in COGS can indicate inefficiencies or the need for better vendor agreements.
• Pricing Decisions: Understanding your true costs allows you to set competitive prices without sacrificing profitability.
• Tax Planning: In the U.S., COGS is deductible and plays a key role in tax calculations.

How Is COGS Related to Cost of Revenue?

In service-based businesses, the term cost of revenue is often used. It includes all direct expenses necessary to deliver the service—like commissions, technical support, and required licenses. COGS is essentially a subset of this, focused on physical goods.

How Does COGS Affect a Company's Financial Performance?

Changes in COGS have a direct impact on profitability:

• If COGS increases without a corresponding price hike, your margins shrink.
• If you reduce COGS while maintaining sales, your gross profits grow.
• An uncontrolled COGS can hide losses until it’s too late to react.
• Regular monitoring lets you spot issues early and adjust your strategy.

Tips to Reduce COGS

Here are some practical tips to optimize your cost structure:

• Negotiate better pricing with suppliers
• Minimize waste in production or storage
• Strengthen inventory control procedures
• Improve demand forecasting to prevent overbuying
• Invest in automation for production or logistics

Conclusion

COGS is more than just an accounting metric—it’s a strategic tool for understanding your cost structure, assessing true profitability, and making smarter business decisions. Whether you sell products or services, knowing how COGS impacts your bottom line is crucial.

At Openbiz, we help entrepreneurs and companies understand and optimize their financial operations to scale safely in the U.S. market. If you’re ready to take your business to the next level, let’s talk. We can help you establish cost control and financial planning best practices from day one.

Frequently Asked Questions (FAQs)

Is COGS the same as total business costs?
No. COGS only includes direct costs tied to the production or acquisition of goods. It excludes general, administrative, and marketing expenses.

Can all companies apply COGS?
No. Only businesses that sell physical products or manage inventory use COGS. Service businesses use other metrics like cost of revenue.

What happens if I miscalculate COGS?
Inaccurate COGS can result in overvalued inventory, distorted financial statements, and poor business decisions.

What’s the best method to calculate COGS?
It depends on your country, product type, and tax strategy. In the U.S., many businesses use either LIFO or FIFO for tax benefits.

‍