Cost of Goods Sold (COGS) is the direct cost of producing the goods your business sells or delivering the services it provides. It is the first deduction from revenue on your income statement and getting it right is essential for accurate gross margin, correct pricing, and proper tax reporting.
COGS tends to be one of the simplest expense items on an income statement, coming right after revenue and before gross profit, and while the math on this line item is straightforward, the challenge for businesses is determining precisely which costs to include or not include in this number.
This seemingly minor modeling error has serious downstream consequences, since any metric that uses gross profit as a basis (including pricing, gross margin, and tax liability) will contain the same imprecision and lead to poor business decisions.
The item I see misclassified constantly is a portion of admin or management salary getting folded into COGS because 'they touch the product somehow. It inflates COGS, understates gross margin, and makes a genuinely healthy business look like it's barely making money on what it sells sometimes by ten points of margin or more.
Abhinav Gupta, CPA, CA, MBA · LinkedInCOGS Formula
COGS = Opening Inventory + Purchases During the Period − Closing Inventory
This formula applies to product-based businesses. For service businesses, COGS = direct labour + direct expenses attributable to delivering the service.
COGS Calculation: Worked Example (Product Business)
| Item | Amount |
|---|---|
| Opening Inventory (start of month) | $25,000 |
| + Purchases of raw materials / stock | $40,000 |
| = Goods Available for Sale | $65,000 |
| − Closing Inventory (end of month) | $18,000 |
| = COGS | $47,000 |
COGS Calculation: Worked Example (Service Business)
A management consulting firm for the month:
| Direct Cost Item | Amount |
|---|---|
| Billable consultant hours (200 hrs × $85/hr) | $17,000 |
| Freelance specialist engaged for client project | $4,500 |
| Project-specific travel and accommodation | $1,200 |
| Client-specific software licence | $300 |
| Total COGS | $23,000 |
What Is and Is NOT Included in COGS
| Included in COGS | NOT Included in COGS (Operating Expenses) |
|---|---|
| Raw materials used in production | Office rent and utilities (general) |
| Direct labour (production workers, billable consultants) | Admin and management salaries |
| Packaging and shipping costs per unit sold | Marketing and advertising |
| Direct factory overhead (production floor utilities) | Accounting and legal fees (general) |
| Inbound freight (cost to bring goods in) | Depreciation of office equipment (non-production) |
| Import duties on purchased inventory | Software subscriptions (general business tools) |
A common error: classifying admin salaries or general overhead into COGS. This artificially inflates COGS, understates gross margin, and misrepresents the business's production efficiency.
Inventory and freight costs are among the most common COGS areas requiring correction during Profitjets onboarding, with COGS reviews typically identifying gross-margin adjustments of approximately 3 to 7 percentage points.
Inventory Costing Methods and Their Effect on COGS
| Method | COGS Calculation | Effect on Gross Margin in Rising-Cost Environment |
|---|---|---|
| FIFO (First In, First Out) | Oldest inventory costs are expensed first | Lower COGS → Higher gross profit (older, cheaper stock sold first) |
| LIFO (Last In, First Out) | Newest inventory costs are expensed first | Higher COGS → Lower gross profit (newer, more expensive stock sold first). Not permitted under IFRS |
| Weighted Average Cost | Average cost of all units in stock | COGS and gross profit between FIFO and LIFO |
| Specific Identification | Actual cost of each specific unit sold | Most accurate; practical only for high-value, unique items |
This choice isn't just an accounting technicality, it genuinely changes the margin your business reports, especially when input costs are moving. Two identical businesses with identical actual costs can report different gross margins purely based on which method they use. Worth knowing which one you're on, and why, rather than inheriting whatever your accounting software defaulted to.
Client Quote
We were calculating COGS using the purchase price of inventory without properly accounting for freight and other landed costs, so our gross margin looked better than it actually was. Profitjets corrected the inventory costing and our reported gross margin moved from 38% to 32%, which showed us that several products were priced too aggressively. We adjusted our pricing to reflect the true cost of each product and started reviewing product-level margins regularly.
Inventory Counts Decide Your Cost of Sales
For a business holding stock, the calculation depends on opening and closing inventory, which means the figure is only as good as the count behind it.
An estimated closing inventory produces an estimated cost of sales, an estimated gross margin and an estimated profit. Businesses that count once a year therefore have eleven months of guesswork and one month that absorbs every correction, which is why December often looks strange in a set of small business accounts.
- Count regularly rather than annually, even if only the highest-value lines
- Investigate differences rather than adjusting to the count, since the difference is information
- Exclude stock you hold but do not own, and include stock you own but hold elsewhere
- Recognise obsolete and damaged stock when you find it rather than carrying it at full cost
Landed Cost, Not Invoice Cost
The cost of goods is what it cost to get them ready to sell, not what appeared on the supplier's invoice. Leaving the rest in expenses overstates margin and understates inventory.
The additions are freight in, duty and customs charges, insurance in transit, and any handling or preparation needed before the goods can be sold. For an importer these can be a substantial proportion of the total, and the margin difference between including and excluding them is not small.
The distinction to hold onto is inward against outward. Costs of getting goods in belong in the cost of those goods. Costs of getting goods out to a customer are selling costs and sit below gross profit. Mixing the two is common and makes margin comparisons between periods unreliable.
Cost of Sales for Service and Software Businesses
Businesses with no physical stock often report no cost of sales at all, which makes gross margin meaningless and hides how the business actually performs.
For a service business, the cost of delivering the service belongs above the line: the time of the people doing the work, subcontractors, and any costs incurred specifically for a client. What is left below is genuine overhead: sales, administration, premises.
For a software business the equivalent is hosting and infrastructure, support costs, and any third-party licence fees embedded in the product. Separating those from research and development is what makes the margin comparable with anything else, and it is the first thing an investor in that sector will look for.
Where the Figure Goes Wrong
The formula is three numbers and the errors are almost always in one of them rather than in the arithmetic.
- Purchases recorded when paid rather than when received, so the period is wrong at both ends
- Freight, duty and handling left in overheads, which understates cost of sales and overstates margin
- Stock damaged, obsolete or already sold still counted in the closing figure
- Goods held on consignment counted as yours, or your stock at a third party left out
- Personal or sample use never removed from inventory
A quick test is to calculate gross margin monthly and look at the pattern. Real margin moves gradually; a figure that jumps about from month to month is usually telling you about the cut-off and the stock count rather than about the business.
Book a free consultation and we will check your cost of sales.
Frequently Asked Questions
Does a service business really have COGS if there's no inventory?
Yes. it just looks different. Billable staff time, project-specific subcontractors, client-specific materials or software licenses, and direct project expenses all count. General overhead, office rent, admin salaries, company-wide software doesn't, the same as it wouldn't for a product business.
What actually happens if COGS is calculated wrong?
Every downstream number gets distorted along with it: gross margin, operating profit, net profit. Overstated COGS makes you look less profitable than you are; understated COGS makes you look more profitable than you are. Both create real problems bad pricing decisions internally, and either overpaying or underpaying tax, plus lenders and investors drawing wrong conclusions from a gross margin that isn't real.
Should I include depreciation in COGS?
Only the depreciation tied directly to production, a machine on the factory floor, for example. Depreciation on office equipment, computers, or anything not directly involved in making or delivering what you sell stays in operating expenses.
How often should I recheck what's classified where?
At minimum, once a year, and any time you add a new cost category, change how you produce or deliver your product, or bring on someone whose role blurs the line between production and admin. Misclassification tends to creep in gradually, one new expense at a time, rather than happening all at once.
Can COGS change from one year to the next?
Yes. Your COGS structure can change when your business changes how it produces or delivers its products or services. For example, hiring employees who move from administrative roles into billable work, bringing production in-house, or changing suppliers can shift costs between COGS and operating expenses. The key is to apply the classification consistently and document the reason for any change.
Written by
Abhinav Gupta, CPA, CA, MBA
Abhinav works with business owners across the US on industry-specific bookkeeping, from dental practices and restaurants to construction and e-commerce. He writes about what each trade's books actually need. Connect on LinkedIn
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