What is cost of goods sold (COGS)?

As a business owner, it’s important to track certain costs to ensure you’re making a profit. One important cost to be aware of is ‘cost of goods sold’ (COGS), also known as cost of sales.

Here, we’ll run through what COGS is, why it’s important, the cost of sales formula and more.

What is cost of goods sold?

COGS refers to the costs and expenses directly involved in producing the goods or services you sell, like the cost of materials and labour.

COGS doesn’t include indirect expenses involved in producing your goods or services, like sales and marketing.

The way you calculate COGS will depend on whether your business sells products or services. We’ll explore both approaches below.

Why is cost of goods sold important?

Tracking the cost of goods sold is important because it tells you whether or not your business is profitable. COGS is subtracted from a company’s revenue to determine its ‘gross profit’. Gross profit is the profit you’re left with after deducting the costs of making and selling a product or providing a service.

Calculating your COGS is useful for other reasons, too. For one, it helps you set the right price for your products. Plus, it’ll help you work out how much your business owes in taxes at the end of the reporting period. Knowing your COGS also helps you determine the value of your stock.

This article assumes you’re using traditional accounting rather than cash-basis.

Calculating cost of sales for goods and products

To calculate cost of goods sold the formula is:

cost of goods sold = cost of stock at the beginning of the reporting period + purchases and other costs during the period - cost of stock remaining at the end of the reporting period.

Calculating cost of sales for services

Businesses that just supply services won’t have COGS, as they don’t sell goods. They will still have a cost of sales, which works in a similar way. For service-based businesses, your cost of sales will be mainly labour, either the cost of employee salaries or subcontractor costs, plus payroll taxes and benefits for workers who generate billable hours.

You won’t have stock but you may have ‘work in progress’ – work that’s incomplete at the end of the period, so can’t be invoiced yet.

In this case, the cost of sales formula for services is: work in progress at the beginning of the reporting period + cost of time spent on all services or projects (complete or incomplete) - time spent on all services or projects not sold.

Whether you’re a product or service-based business, it’s important to calculate a cost of sales to ensure you’re profitable.

This article is for information purposes only and does not constitute legal, tax or accounting advice. You should get professional advice if you need help to understand your legal rights or to manage your accounting or tax affairs.

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