What Is COGS? Understanding Cost of Goods Sold
The cost of goods sold, also known as COGS, is a term many people have trouble grasping. Let’s take a look at what COGS is, how to calculate it, and why it plays a key role in profitability modeling.
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COGS is reported on your income statement, along with revenue. It’s a key component in calculating two crucial business figures—gross profit, and gross profit margin. Gross profit is calculated by subtracting costs of goods sold from revenue, and its margin is obtained by dividing gross profit by revenue
Profit Frog makes COGS calculations easy with our financial modeling software, which was built specifically for small businesses. We walk you through the different business drivers, such as cost of goods sold, sales, and operating costs, and let you put each one in.
With Profit Frog, you can dynamically plan your company’s future by modeling different scenarios and creating a business plan that grows with you. It’s all about maximizing profitability, no matter what variables the world throws at you. We help you chart the most profitable course, proactively.
That’s why we’re the leading small business forecasting software.
What is cost of goods sold?
Cost of goods sold (COGS) is the direct accumulated costs of acquiring or creating products, or of delivering services. The cost of goods sold definition given by the US Generally Accepted Accounting Principles (GAAP) defines COGS as the cost of inventory items sold during a given period.
Our COGS definition includes all direct costs associated with creating a product or providing a service. (Yes, service businesses have COGS, too.)
How to calculate COGS
There’s the traditional COGS accounting method (based on inventory), and then there’s the Profit Frog way. For the majority of small businesses, the Profit Frog way is far superior.
Inventory-based COGS accounting
Traditionally, COGS and inventory go hand in hand. Determining the cost of goods sold was always based on periodic physical inventory assessments that compare the inventory at the beginning of a period with that at the end of the period. COGS was derived from calculating inventory turnover during the interval.
Using this method, the company needs to do an inventory count as well as an inventory value calculation for the beginning and end of an accounting period.
Disadvantages of inventory-based COGS calculations:
- Backward-looking and slow: you get insights much later than you need them
- Not applicable to companies that have no inventory, such as SaaS companies and service businesses
Profit Frog COGS accounting
We introduce a better approach to COGS. Input your costs on a regular basis and have a real-time view into COGS, OPEX, profitability, and all the other things that matter.
Rather than waiting until an accounting period has closed (the inventory method), you can have the very latest COGS data at your fingertips. You can then use the latest numbers to conduct scenario planning exercises and to strategically forecast the future.
For service businesses, the Profit Frog approach is a lifesaver, given that they can’t use the inventory method anyway.
Benefits of Profit Frog’s COGS accounting approach:
- You have the latest insights at your fingertips and can make decisions much faster
- All types of businesses can use it, not just manufacturers
What accounting method for COGS is best?
There are three variations on the traditional inventory valuation method for calculating COGS. All are backward-looking.
For most small businesses, we recommend none of these three inventory valuation methods. Instead, we favor a real-time COGS tracking model that gives you actionable insight into your business on a regular cadence.
Three traditional COGS accounting methods
For the sake of education, however, let’s look at the three traditional accounting methods for tracking COGS. All of these inventory costing methods are based on computing COGS retroactively after the books for an accounting period have been closed. They are the FIFO method, the LIFO method, and the WAC valuation method.
- First in, first out (FIFO). The earliest goods that get manufactured or purchased are sold first. Because prices tend to go up over time, businesses using the FIFO method sell their least expensive products first. This translates to lower COGS under FIFO; which is why net profit while using FIFO may increase over time.
- Last in, first out (LIFO). The LIFO method mandates that the latest inventory gets sold first. Costs usually increase over time, leading to later inventory having a higher cost basis than earlier inventory. This dynamic can lead to higher COGS, bringing net income down over time.
- Weighted average cost (WAC). Regardless of the purchase date, the average price of all inventory is used as a cost basis for each individual product sold. By averaging prices throughout the period, the averaging method smooths out price fluctuations, making the calculation more simple and straightforward.
A better way to track COGS and other expenses
Instead of using these inventory-based accounting methods, which only show what a company’s COGS are after an accounting period has ended, Profit Frog shows what a company’s COGS are in real time.
By deferring COGS calculations until after the books are closed on an accounting period, many business owners make a crucial, sometimes fatal mistake: they don’t have a real grasp on their cost of goods sold. Hence, they don’t know where to focus their cost reduction efforts.
This is the trap that Profit Frog founder Mark Buff fell into while heading Mohu, a Raleigh-based consumer electronics company. “We lost track of where our costs were,” Buff recalls. While Mohu survived—many small businesses don’t—it could have thrived even more had Buff had access to a tool like Profit Frog.
Profit Frog didn’t exist back when Buff was CEO of Mohu. He sold the company and founded Profit Frog so that other small business owners could have real-time intelligence on their costs.
In addition to modeling costs (COGS and OPEX), Profit Frog allows small businesses to model growth, new market opportunities, and other variables.
What Is a COGS report?
A COGS report is a document that summarizes all the direct costs related to the production of goods or the delivery of services. It covers a specified period of time (for example, a month, a calendar year, or a quarter) and usually compares COGS for the current period to COGS from the previous period.
It’s important for your cost of goods sold report to be thorough, so you can correctly calculate your COGS and use them as an expense.
For financial planning and analysis (FP&A) purposes, COGS reports are crucial inputs, allowing business owners and stakeholders to model future costs and business profitability.
Profit Frog makes COGS reporting easy. Start your free trial today.
What costs are included in COGS?
COGS include all the costs incurred to make or acquire a product or to deliver a service. If you’re reselling goods, your COGS will be the cost of inventory—the direct costs of purchased products and the transportation costs, and any duties paid by your company.
If you’re making a product, the following fixed and variable costs should generally be included in cost of goods sold:
- Raw materials
- Factory overhead
- Transportation costs
- Parts and tools used in production
- Factory labor
- Storage costs
What is not included in COGS?
Because COGS costs relate to making a product or delivering a service, the following expenses are not included in COGS.
- Indirect costs associated with labor (labor costs not directly involved in manufacturing or delivery)
- Costs of marketing are not COGS
- Utilities
- Rent or lease payments
- Predictable line items such as office supplies, insurance, HR expenses
- Research and development (R&D) costs
- Overhead costs not directly related to making or delivering a product or service
See our article on COGS vs selling, general, and administrative (SG&A) expenses for more detail on this point.
Are cost of goods sold an expense?
Yes, the cost of goods sold is a business expense. That means COGS can be used for tax purposes—another reason to categorize COGS expenses properly. The main point to remember about COGS and taxes is that raw materials, manufacturing, direct labor costs, and other direct expenses can be deducted from your taxes as an expense for all items sold or services delivered in that year.
How do you calculate COGS?
You can calculate the cost of goods sold with a formula, or you can use Profit Frog if you’d rather save some time and brainpower.
The conventional formula for a COGS calculation is mostly used by accountants.
And, if you’re a small business owner who doesn’t have the time to dive into the COGS formula, our itemized COGS calculator can be quite helpful.
Get started with your free Profit Frog trial today.
Variable cost of goods sold formula
The traditional formula for calculating COGS is:
Calculating cost of goods sold:
COGS = (beginning inventory + purchases and other costs) – ending inventory balance
- Beginning inventory: a business’s inventory at the beginning of an accounting period.
- Purchases: costs incurred to produce a good or service during an accounting period.
- Ending inventory: the inventory remaining at the end of an accounting period.
This formula may seem simple at first glance, but it does require you to look back at all of your inventory for an accounting period. So, if you don’t have an accountant to help you make sense of all the numbers, getting your COGS metrics with this formula can be a time-consuming task.
Fortunately, Profit Frog simplifies COGS calculations for owners of small businesses. We also allow COGS to become a dynamic part of the financial modeling process. Not only do we help you accurately report them for past accounting periods, we also allow you to forecast them into the future by dynamically adjusting them based on hypothetical scenarios.
This is a powerful exercise that gives you proactive insight into how your business will perform under different potential scenarios. Armed with this knowledge, you can steer your company to maximum profitability no matter what happens.
Our cost of goods sold calculator
The traditional COGS formula can be hard to understand, especially if you offer a service and don’t have a lot of raw materials or inventory. Profit Frog takes a different approach to COGS, specifically designed to help small business owners map out a scenario and plan for the future.
By taking an itemized approach to COGS, we help you get intimately familiar with the direct costs of making your goods and providing services. We also make COGS calculations super easy with our guided walk-through process.
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The items we take a look at when calculating COGS are:
- Direct materials needed to make your product
- Direct labor costs
- Shipping costs to get the materials to your production factory
- The cost of waste involved with making your product
- … and other direct costs
This process helps you forge a deep knowledge of what goes into producing each item you sell or the service you provide. Ultimately, this leads to a better understanding of your business and where your profit centers lie.
If you want to make COGS calculations and financial forecasting easy, try our COGS calculator!
The items we take a look at when calculating COGS are:
- Direct materials needed to make your product
- Direct labor costs
- Shipping costs to get the materials to your production factory
- The cost of waste involved with making your product
- … and other direct costs
This process helps you forge a deep knowledge of what goes into producing each item you sell or the service you provide. Ultimately, this leads to a better understanding of your business and where your profit centers lie.
If you want to make COGS calculations and financial forecasting easy, try our COGS calculator!
Cost of goods sold example problems
COGS can be a difficult concept to grasp, so let’s go over it in practice with some examples of costs of goods sold.
Cost of goods sold example #1
Let’s say you’re making and selling premium leather shoes. In this instance, your COGS would include raw materials (leather, rubber, anything you would need to make a shoe), tools needed to make shoes, and the labor involved in manufacturing the shoes.
Consistent costs, such as factory overhead, are considered fixed costs, as they stay the same from month to month while the price of labor and materials varies.
Both the fixed and varied costs related to creating your product—in this case, shoes—should be included in your COGS. The costs of renting and maintaining the store you’re selling the shoes from, however, are a non-COGS expense.
To deduct these costs from your taxes, you will need to include all COGS expenses in your income statements. However, you can only include the costs of goods you’ve sold in income statements. Thus, if you made 200 pairs of shoes but only sold 100 pairs, your COGS statement will only include the costs of 100 shoes.
Cost of goods sold example #2
In this example, we’ll take a look at a retail store that doesn’t produce its own items. Rather, it makes a profit by reselling items. To calculate their COGS, the retail store owners need to take into account the following costs:
- The costs of purchasing items from the manufacturers
- The costs of transporting items to their storage
- The labor costs related to item transportation
So, if they’ve sold 100,000 items this month, they would need to calculate the above-mentioned metrics for each unit sold to get their monthly COGS.
And, if they want to calculate their business’s gross income as well, they can do so by subtracting their COGS from their revenue for a certain time period.
COGS vs operating expenses
COGS and operating expenses (OPEX) are both business expenses, but they are mutually exclusive categories. If an expense can be classified as COGS, it is not OPEX; if it is OPEX, it cannot be COGS.
While COGS are expenses directly related to delivering a service or producing a good, OPEX are those costs necessary to sustain day-to-day operations.
Here are some things to remember when contrasting operating expenses vs COGS.
- COGS varies based on number of goods produced (or customers serviced)
- OPEX remains much more constant; an increase in sales doesn’t change OPEX much
Operating expenses include selling, general, and administrative (SG&A) expenses, such as legal fees, office supplies, and insurance. COGS, on the other hand, includes the cost of materials, direct manufacturing labor, and other direct costs.
Is COGS a debit or credit?
Being a cost, COGS is a debit on your income statement or balance sheet. Anything that costs money is a debit, while anything that increases a company’s value or revenue is a credit.
Debits
- Accounts payable and other debts are debits
- All costs (COGS, OPEX, and other expenses) are debits
Credits
- Accounts receivable is a credit
- Inventory is a credit
- Equipment and real estate are credits
- Sales are credits
Is COGS a fixed or variable cost?
COGS can include both fixed and variable costs, but it is almost always predominantly variable. The reason for this is that to produce more products, more materials will be purchased, more manufacturing labor will be on the payroll, and other direct expenses will be incurred in proportionally greater numbers.
In the case of a service business, taking on more customers entails ramping up direct expenses. For example, a plumbing company will have to hire more plumbers, pay for more plumbing supplies, and have more vehicles on the road.
Because COGS fluctuates based on volume (of products produced or services delivered), COGS is mostly variable expenses. However, there may be certain COGS that remain constant—up to a point.
How can I calculate my COGS percentage?
You can calculate your COGS percentage quite easily. Just divide the total cost of goods sold for an accounting period by your total revenue for that same period.
Keeping your COGS percentage as low as possible is a crucial part of optimizing profitability.
If you’re a Profit Frog user, we’ll calculate your COGS percentage for you and help you spot key areas where you can minimize COGS and maximize profits.
Profit Frog makes COGS calculations a breeze
If you need help with calculating your COGS or any other area of financial modeling, Profit Frog is here to help. We allow small businesses to model their profitability based on different scenarios unique to their business. By planning for different scenarios, you can navigate your business strategy and get the most profit while avoiding risk. To try our software, get started here!
Cost of goods sold FAQ
What percentage should COGS be?
The ideal COGS percentage depends on what you’re selling. However, as a general rule, your COGS and the costs of selling the product should not exceed 65% of your gross revenue. You should aim for your COGS expenses to be as low as possible, while maintaining your product’s quality.
Is the cost of sales and COGS the same?
Yes, cost of sales and COGS (cost of goods sold) refer to the same concept. So, if you see the cost of sales mentioned in your annual reports, don’t worry, that’s just another way of saying COGS.
Can you have COGS without sales?
No, you can’t have COGS without sales. Since you can only calculate the cost of goods sold once the goods are actually sold, you will need to make sales in order to have COGS.
How do you calculate COGS on Excel?
You can calculate the cost of goods sold in Excel by adding all the values needed to make the calculation (beginning inventory, purchases, and ending inventory) to an Excel balance sheet. These three values should be variables, so Excel can easily compute the results once you put in the formula.
If this seems too difficult, you can also rely on an Excel template to help you get started. However, using a premade template may stunt your understanding of the importance of COGS and how to use it to your company’s benefit.
If your brain starts to hurt at the mere thought of Excel, Profit Frog is the solution you’re looking for. We exist to save small business owners from ever having to deal with Excel. Get started on your free Profit Frog trial and you’ll never have to think about Excel again.
What is a cost of goods sold statement?
A cost of goods sold statement is a document that details the costs of goods sold for a particular accounting period in more detail than a typical income statement. It’s usually created by an accountant professional, though it’s rarely found in practice since it’s not considered to be a crucial part of a financial statement.
What is net income?
Net income, also known as net sales, net profits or net earnings, is a term commonly found in a profit and loss statement. It refers to how much you’ve made in a certain period with consideration of all expenses needed to make said profit. For example, you can get your net profit for the current period by subtracting COGS, general expenses, interest, and taxes from the sales you’ve made.
Can you have COGS without inventory?
Yes, some service businesses can have COGS without inventory.
Is cost of goods sold an operating expense?
No, COGS and OPEX are distinct and mutually exclusive categories of business expenses.
Do you debit or credit COGS?
COGS is a debit on your company’s income statement or balance sheet.
Further reading on small business finance
Can I include distribution costs in COGS?
Profit and loss vs cash flow—what are the differences?
Tips for calculating year-over-year growth
Understanding scenario planning templates
Scenario planning advantages and disadvantages
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