If you’re a small business owner or a startup founder, you’ve probably heard about Cost of Goods Sold (COGS). But what does it really mean, and why is it crucial for your business’s success? Understanding COGS isn’t just about accounting—it’s about making smart decisions for profitability, pricing, and more. 

This blog walks you through everything you need to know about COGS, from defining the term to showing you how to calculate it and leverage it for your business growth. 

1. What is Cost of Goods Sold (COGS)? 

COGS represents the direct costs involved in creating the products your business sells. These include things like materials, manhours, and even manufacturing overheads. Essentially, any expense that contributes directly to a product’s creation lands under COGS. 

COGS provides critical insights into your business’s efficiency and profitability. It’s a fundamental metric that shows how much you’re spending to produce inventory relative to your sales. 

Example 

If you run a bakery, the cost of flour, sugar, and eggs counts as part of your COGS. However, your shop rent and website maintenance costs do not—those are general operational expenses.

2. What are the components of COGS? 

COGS isn’t one-size-fits-all. It includes different types of costs depending on your business. 

Here are the main components typically included in COGS:

• Materials: Raw ingredients or parts used to create your product (e.g., fabric for making clothes or ingredients for prepared meals). 
• Payroll: The wages you pay to employees directly involved in production (e.g., sewing a shirt, baking a cake). 
• Manufacturing Overheads: Indirect costs required to produce goods, such as equipment depreciation or utility costs used in production. 

Note 

General overheads like office expenses or marketing costs are not included in COGS. Only expenses tied directly to production count. 

3. How do I calculate COGS? 

Fortunately, calculating COGS follows a straightforward formula:

COGS = Beginning inventory + Purchases during the period – Ending inventory 

Breaking it down:

• Beginning inventory: The value of inventory on hand at the start of the accounting period. 
• Purchases: All costs for new inventory bought or manufactured during the period. 
• Ending inventory: The value of unsold inventory at the period’s end. 

Example Calculation 

Imagine you run a small boutique that sells handmade gifts. If:

• Your beginning inventory is $5,000, 
• You spent $8,000 on materials and production, and 
• Your ending inventory is $2,000, 

Then your COGS would be: 

$5,000 + $8,000 – $2,000 = $11,000 

This $11,000 represents the cost of creating the products you sold during the period. 

4. What are COGS accounting methods? 

How you calculate and report COGS can depend on the accounting method you choose for inventory valuation. Here are the most common methods:

• First-in, First-out (FIFO): Oldest inventory is sold first. This is great when prices rise as the lower-cost items are accounted for first, lowering COGS. 
• Last-in, First-out (LIFO): Newest inventory is sold first. When prices rise, LIFO increases COGS but reduces taxable income. 
• Weighted average cost (WAC): Assigns an average cost to all inventory. Simple and ideal for businesses with indistinguishable inventory items. 

Pro Tip 

Consult with your accountant to identify the best method for your business—tax implications vary by approach. 

5. Why does understanding COGS matter? 

Knowing your COGS is a game-changer for managing and growing your business. Here are some ways it benefits you:

Profitability analysis 

COGS is crucial for calculating your gross profit. Subtracting COGS from your revenue reveals how much your products are contributing to your bottom line. 

Pricing strategy 

Understanding how much each product costs to make allows you to set prices that cover expenses while leaving room for profit. 

Inventory management 

COGS helps track costs related to unused or unsold inventory, ensuring you’re not overstocking items that don’t sell. 

Financial reporting 

COGS is a must for accurate income statements and tax reporting. It demonstrates operational efficiency—which is key for attracting investors or securing loans. 

Tax benefits 

COGS is deductible for tax purposes, reducing your taxable income. The more precise your calculations, the better-positioned you’ll be during tax season. 

6. How your accountant can help 

Managing COGS can be complex, but you don’t have to go it alone. Your accountant is your best ally for navigating this process. 

They can:

• Help you choose the right accounting method (FIFO, LIFO, etc.). 
• Ensure all eligible expenses are accounted for (and not missed!). 
• Revise your tax strategy while staying compliant with regulations. 

A thought 

Why struggle with numbers when you can partner with someone who lives and breathes accounting? Freeing up your time lets you focus on growing your business. 

Understanding your Cost of Goods Sold isn’t just an accounting exercise—it’s the foundation for business success. By calculating and tracking COGS effectively, you’ll empower yourself to make better decisions about pricing, profitability, and growth. 

If you’d like help navigating COGS or developing your financial strategy, reach out to us today. Your business’s future is worth the investment!