Calculate COGS and gross profit margin
Cost of Goods Sold (COGS) represents the direct costs of producing goods sold by a company. It includes raw materials, direct labor, and manufacturing overhead directly tied to production. COGS is subtracted from revenue to calculate gross profit.
The basic COGS formula uses inventory accounting: Beginning Inventory + Purchases - Ending Inventory = COGS. If you start with $50,000 inventory, purchase $200,000, and end with $40,000, your COGS is $210,000.
COGS is crucial for determining profitability and pricing. A high COGS relative to revenue indicates tight margins. Different industries have vastly different COGS profiles—software has near-zero COGS while manufacturing has substantial material and labor costs.
Materials and parts directly used in products sold.
Wages for workers directly producing goods.
Factory utilities, equipment depreciation, production supplies.
Shipping costs to get inventory to your location.
| Industry | Typical COGS % | Gross Margin | Notes |
|---|---|---|---|
| Software/SaaS | 10-25% | 75-90% | Low marginal cost |
| Retail | 60-75% | 25-40% | Product resale |
| Manufacturing | 50-70% | 30-50% | Material + labor |
| Restaurants | 28-35% | 65-72% | Food cost target |
| Grocery | 75-80% | 20-25% | Low margin, high volume |
Volume discounts, payment terms, and competitive bidding reduce material costs.
Reduce waste, optimize processes, and minimize rework to lower production costs.
Calculate COGS per product/SKU. Identify and address low-margin items.
FIFO, LIFO, and weighted average give different COGS. Choose appropriately and be consistent.
Exclude: selling expenses, marketing, administrative salaries, rent for non-production space, R&D, and distribution costs (freight out). These are operating expenses, not COGS.
FIFO (First In First Out) assumes oldest inventory sold first—better matches physical flow. LIFO (Last In First Out) can reduce taxes during inflation. FIFO is more common and required under IFRS.
COGS is deductible. Higher COGS = lower taxable income. However, artificially inflating COGS is fraud. Use proper accounting methods and be consistent year to year.
For product companies, they're interchangeable. Service companies use Cost of Sales (or Cost of Revenue) since there's no inventory—it includes direct labor and service delivery costs.
A boutique starts the year with $50,000 in inventory, purchases $200,000 of new goods, and finishes the year with $75,000 on the shelf.
Result$175,000 COGS
Apply the formula: $50,000 + $200,000 - $75,000 = $175,000. If revenue was $300,000, gross profit is $125,000 and gross margin is 41.7%.
COGS covers direct costs of producing goods sold—materials, direct labor, and manufacturing overhead. Operating expenses (OpEx) cover indirect costs like marketing, administrative salaries, rent for office space, and R&D. COGS sits above the gross profit line; OpEx sits below it on the income statement.
FIFO (First In First Out) sells oldest inventory first, producing lower COGS and higher profits during inflation. LIFO (Last In First Out) sells newest inventory first, producing higher COGS and lower taxable income when prices rise. Weighted Average smooths the cost per unit across all inventory. IFRS prohibits LIFO; US GAAP permits all three.
Gross profit equals revenue minus COGS. Every dollar reduction in COGS flows directly to gross profit. For example, cutting COGS from $175,000 to $160,000 on $300,000 revenue raises gross profit from $125,000 to $140,000 and gross margin from 41.7% to 46.7%.
Yes. COGS is reported on IRS Schedule C (sole proprietors) or Form 1125-A (corporations and partnerships) and reduces taxable income dollar for dollar. The IRS requires consistent inventory accounting methods year to year; changes require Form 3115.
Service businesses without inventory typically report Cost of Services or Cost of Revenue instead. It includes direct labor for service delivery, subcontractor fees, and software/tools tied to producing the service—but excludes back-office salaries and marketing.
Exclude selling expenses, marketing, administrative salaries, office rent, R&D, freight-out (shipping to customers), and depreciation on non-production assets. These belong in operating expenses, not COGS.
Calculate COGS at minimum quarterly for financial statements and annually for tax filing. Many product businesses track COGS monthly to monitor margin trends and catch sourcing problems early. Real-time perpetual inventory systems calculate COGS at each sale.
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