Cost of Goods Sold, also known as Cost of Sales and abbreviated to COGS, refers to the direct costs involved in producing goods or services sold by a business.
What is Cost of Goods Sold?
Cost of Goods Sold represents the expenses directly tied to producing a product or delivering a service. These costs can include:
- Stock Purchases (items bought for resale)
- Raw Materials (essential components for making products)
- Labour Costs (wages for workers directly involved in production)
- Manufacturing Costs (equipment and tools used in production)
- May include depreciation of production equipment and factory-related overhead, not capital purchases
- Subcontractor Fees (when outsourcing essential tasks)
- Only if directly related to production or service delivery
COGS does not include indirect expenses such as rent, office supplies or marketing costs. However, Inbound Logistics (such as shipping raw materials to your premises) falls into COGS, whereas Outbound Logistics (such as deliveries to customers) does not.
How to Calculate the Cost of Goods Sold
The COGS formula is straightforward:
COGS = Beginning Inventory + Purchases – Ending Inventory
- Beginning Inventory is the value of stock at the start of the period
- Purchases are any additional inventory bought during the period
- Ending Inventory is the remaining stock at the end of the period
For example: If a business starts with £20,000 worth of stock, buys an additional £10,000 and has £5,000 left at the end, the COGS calculation would be:
COGS = £20,000 + £10,000 – £5,000 = £25,000
This means the business spent £25,000 directly on goods sold during that period.
Why is COGS Helpful?
The Cost of Goods Sold helps determine Gross Profit. This is the total income from sales minus the direct costs of making those sales. The formula is:
Sales Revenue – COGS = Gross Profit
By analysing Gross Profit, businesses can identify whether their pricing strategy is effective.
For example: If a retailer’s Gross Profit Margin is only 20%, this may indicate that either production costs are too high or the selling price is too low. In contrast, many successful retailers aim for a margin of 50% to 70%.
COGS vs Operating Expenses
Many confuse the Cost of Goods Sold with Operating Expenses, but they are different. While COGS includes direct costs, operating expenses cover costs that keep the business running, such as:
- Rent
- Utilities
- Office Supplies
- Sales and Marketing
- Insurance
Unlike COGS, these costs are incurred regardless of whether a business sells products or not.
What Businesses Use COGS?
The Cost of Goods Sold applies mainly to product-based businesses such as retailers and manufacturers.
Service-based businesses, such as accountants, generally do not track inventory, so they do not use COGS in the traditional sense. Instead, they track “Cost of Sales” or “Cost of Services Rendered”, which can include:
- Direct Labour
- Subcontractor Fees
- Project-Specific Materials
Businesses that offer both goods and services (such as hotels and airlines) can include the cost of tangible products in their COGS calculation.
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