COGS & COS: How are They Calculated and Why Does it Matter?

Cost of goods sold (COGS) and cost of sales (COS) refer to expenses directly related to creating the products or providing the services that generate revenue for your business. Inventory-based businesses that sell goods record their product sourcing and manufacturing costs as COGS. Businesses that sell services commonly drop the word "goods" from the name of this financial category and call it “cost of sales" instead (or interchangeably,  “cost of service” or “cost of revenue.”)

In all cases, gross profit (GP) is simply the profit remaining after subtracting COGS or COS from revenue. Gross margin (GM) is the percentage you get when you divide GP by revenue. GM is a critical metric for most scaling businesses to budget around. It's often a pivotal metric to make or break a successful equity capital raise or bank debt negotiation because it determines how much profit is generated from each new dollar of sales revenue.

To understand your GM, it's crucial to calculate your COGS or COS correctly. These metrics not only help you to make informed management decisions that optimize both profits and cash flow, but also enable investors and lenders to determine your business' valuation and creditworthiness.

Unpacking COGS for Inventory-Based Businesses

SPRCHRGR generally defines COGS as "all costs associated with getting a unit of product into retail packaging and ready for sale." This usually includes:

• Sourcing, manufacturing and retail packaging costs themselves

• Inbound freight costs

• Any tariffs and warehousing costs to receive finished goods from an external supplier and store them until they're sold

COGS can also include "tricky bits" such as consumable parts used in the production process along with factory overhead and labor costs. Those should all be allocated on a per-unit basis whenever possible.

Some expenses inherent in the manufacturing process are typically excluded from COGS, however, even though they're variable costs that increase in direct proportion to each incremental unit of product sold. These include the costs of:

• Bundling finished goods into cartons and stacking them in pallets for wholesale

• Dropping individual items into shipping boxes

• Purchasing cartons, pallets and boxes themselves

• Outbound shipping and insurance

There are some wildcards here – for example, some businesses consider fulfilment costs to be part of COGS while others consider them selling costs. They’re direct costs either way, so regardless of where you classify them on the P&L it’s important to consider those costs in your contribution margin analysis.

COGS for Other Business Models

Defining COGS can be tricky for newer business models, like software-as-a-service (SaaS), marketplaces, fintech platforms and on-demand delivery companies, partly because there aren't many time-tested public datasets to establish precedents. (Here's a good thought piece from mid-2023 on what should go into COGS for a typical SaaS company.)

For other business types such as medical device manufacturers and IoT companies that bundle physical devices together with the software subscriptions required to operate the hardware, COGS can include a combination of tangible product manufacturing costs, certain labor costs, plus software and server expenses necessary to make the product or service work.

Key COS considerations

Service-based businesses have the same need to understand how profitable they are by project, by client, and by service line. So they typically track work effort (hours and dollars spent) at that granular level of detail, then precisely allocate labor costs to COS at that same level of detail. Sophisticated professional service agencies also match the timing between service revenue and corresponding labor costs using accrual-basis accounting methodology. The variety of billing practices for service-based businesses (billing hourly as work is completed, vs various milestone or time-based billing schedules) require some fancy footwork for skilled accountants to accurately line up revenue and COS in the correct time periods relative to when the revenue was actually earned.

All this extra work gives an accurate read on where the company's profit is really coming from – and where the firm might actually be losing money.

Let an expert guide you

Once you realize just how many ways there are to categorize expenses – not to mention the different accounting methods you can use to keep track of everything – you begin to appreciate the importance of obtaining expert financial guidance.

In the meantime, click here to read more about Cost of Goods Sold: A Deeper Dive.