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Cost of Goods Sold (COGS): Meaning, Examples, and Inclusions
Key takeaways
COGS is the cost of the products a business sold in a period, including what it cost to buy or make them and get them ready for sale.
It covers goods sold, not goods bought. Stock you have not sold stays on the balance sheet as inventory.
A cost belongs in COGS if it was incurred to buy or make the goods and bring them to the place and condition in which they are sold. Costs of selling, delivering, and running the business do not.
Revenue minus COGS is gross profit, so every error in COGS changes your gross margin.
Introduction
A business can post healthy sales month after month and still run short of cash. Often the cause sits in one line of the profit and loss (P&L) statement; the cost of what it sold was never measured properly, so every price and margin built on that number was off.
Cost of goods sold (COGS) is usually the largest cost a product business reports. Put one cost on the wrong side of that line, and gross margin, pricing decisions, and the tax return all move with it.
This guide explains what COGS is, what belongs in it, where it appears in your financial statements, and how to read it. Working the number out from your stock records has its own guide, linked in the first section.
What is cost of goods sold (COGS)?
Cost of goods sold (COGS) is the cost of the products a business sold during a period, including what it paid to buy or make them and to get them ready for sale. It appears on the income statement below revenue, and subtracting it from revenue gives gross profit.
COGS stands for cost of goods sold. You will also see it called cost of sales or cost of products sold. Some companies use cost of revenue, a label that can cover more than goods, as the comparison further down explains.
In its shortest form:
COGS = Beginning inventory + Purchases − Ending inventory
For a worked example, costing methods, and the journal entries, see the cost of goods sold formula guide.
What COGS includes and what it doesn't
Most COGS errors start with classification, not arithmetic. The table sorts the costs a product business most often has to place.
Cost | In COGS? | Why, and where do people slip? |
Purchase price of goods for resale | Yes, net of trade discounts and supplier rebates | It is the cost of the goods. Booking rebates as separate income leaves COGS overstated. |
Freight-in and import duties | Yes | Getting the goods to you is part of what they cost. Often left in a general transport account. |
Outbound shipping and delivery to customers | No | A cost of delivering the sale. Some large companies present it within cost of sales as a disclosed policy, but it never enters inventory. |
Goods and services tax (GST) or value-added tax (VAT) on purchases | Only if you cannot recover it | Tax you claim back as an input tax credit was never a cost. Tax you cannot recover, because the credit is blocked or you are not eligible. |
Direct materials | Yes | What the product is made from. |
Direct labor | Yes | Wages of the people who make or assemble the product. |
Manufacturing overhead: factory rent and utilities, production equipment depreciation, indirect production labor such as supervisors and maintenance staff | Yes | Needed to turn materials into products. Often left in overheads alongside office costs. |
Idle factory capacity and abnormal waste | No; charged to the period | Fixed cost is left unabsorbed in a slow month, and waste beyond the normal rate adds nothing to the goods, so they are not added to stock. |
Packaging that is part of the product, such as the bottle or retail box | Yes | It is sold with the goods. |
Shipping cartons, mailers, and void fill | No | Used to deliver the order, not part of the product. |
Storage that is a step in production, such as aging cheese or seasoning timber | Yes | Needed before the goods can be sold. |
Storage of finished goods waiting for buyers | Generally no | The goods are already in saleable condition. |
Write-downs of obsolete or damaged stock | Usually reported in COGS | Stock worth less than it cost is written down to net realizable value: its selling price less the costs to finish and sell it. |
Sales commissions | No | A cost of making the sale. |
Marketing and advertising | No | Spent to find buyers. |
Office rent and administrative or sales salaries | No | Costs of running the business, not of the goods. |
Interest and financing costs | No | A finance cost, reported below operating profit. |
Research and development (R&D) | No | Spent on future products, not the ones sold. |
A test that sorts most costs
A common shortcut asks whether a cost would exist if nothing were produced. It misfiles factory rent, which is paid in an idle month too.
Ask this instead:
Was this cost incurred to buy or make the goods and get them to the place and condition in which they will be sold?
If yes, it is part of inventory and becomes COGS when the goods sell. If it was incurred to sell, deliver, or run the business, it is an operating expense.
Where COGS appears in your financial statements
COGS sits on the income statement, directly below revenue. The illustrative P&L below shows the lines around it and what happens when one cost lands on the wrong line.
Line | Correct (illustrative) | With 10,000 of outbound shipping booked to COGS |
Revenue | 200,000 | 200,000 |
Cost of goods sold | (120,000) | (130,000) |
Gross profit | 80,000 | 70,000 |
Gross margin | 40% | 35% |
Operating expenses | (50,000) | (40,000) |
Operating profit | 30,000 | 30,000 |
Operating profit does not move, so the error is easy to miss. Gross margin drops five points, and gross margin is the number most businesses price from and show to lenders. A business reading 35% may reprice or drop a product line that was in fact earning 40%.
COGS is not on the balance sheet, and neither is gross profit; both are income statement figures. The balance sheet shows inventory, the cost of unsold stock, as a current asset.
On US tax returns, sole proprietors report COGS in Part III of Schedule C, and corporations and partnerships on Form 1125-A, with Internal Revenue Service (IRS) Publication 334 as the guide.
From inventory to COGS: when a cost becomes an expense
A business buys 1,000 units at 50 each in March (illustrative). The 50,000 goes into inventory, not into the P&L.
| March | April |
Units sold | 600 | 400 |
COGS | 30,000 (600 × 50) | 20,000 (400 × 50) |
Inventory at month end | 20,000 | 0 |
Each unit's cost is expensed in the month it sells, alongside the revenue it earns. That is the matching principle. Expensing all 50,000 in March would understate March profit and overstate April's.
A perpetual inventory system records this move at each sale; a periodic system works it out from a period-end count, using the journal entries for both systems. When purchase prices change, which units count as sold depends on the costing method: first in, first out (FIFO), weighted average cost (WAC), or, where permitted, last in, first out (LIFO). The FIFO vs LIFO guide compares them.
COGS vs. operating expenses, cost of sales, and cost of revenue
Four labels cover the costs between revenue and profit, and they are often used loosely.
Term | What it covers | Where it sits | Who typically uses it? |
Cost of goods sold (COGS) | The cost of buying or making the goods sold in the period | Income statement, below revenue | Product businesses, especially in the US |
Cost of sales | The same idea can also include the direct cost of services sold alongside goods. | Income statement, below revenue | Many companies are reporting under IFRS for goods and services alike. |
Cost of revenue | Direct costs of earning all revenue, including services and subscriptions, such as hosting or support staff | Income statement, below revenue | Software, subscription, and mixed product and service companies |
Operating expenses, or selling, general, and administrative expenses (SG&A) | Costs of selling the goods and running the business: marketing, sales staff, office rent, admin salaries, outbound delivery | Income statement, below gross profit | All businesses |
Cost of sales is not a services-only term; plenty of retailers and manufacturers use it for exactly what a US company calls COGS. Cost of revenue has no fixed contents: one software company includes hosting and support, another draws the line elsewhere, and the notes to the accounts say which.
The line that matters most is the one between all three and operating expenses. Above it sit the costs of the goods or services delivered; below it, the costs of finding customers and running the company.
What gets misclassified by type of business
The definition is the same for everyone. The mistakes differ, and each type of business has a habitual one.
Manufacturers tend to leave production costs as overhead. Factory supervisors, maintenance staff, and equipment depreciation get booked alongside office costs, so COGS looks low and gross margin looks better than it is. Advisers at the Business Development Bank of Canada (BDC) describe the same pattern, with labor booked entirely to overheads instead of being split between production and administration. Tracking costs by job or batch, as in job order costing, makes the split visible.
Distributors and wholesalers often leave freight-in in a general transport account within operating expenses and record supplier rebates as other income instead of netting them off the cost of stock. The first understates COGS, and the second overstates it. Either way, item margins stop being reliable.
Ecommerce sellers tend to err the other way. Outbound shipping, marketplace commissions, and fulfillment fees get added to product cost because they arrive on the same settlement statement. They are costs of selling and delivering, so folding them in understates gross margin. Tracking them per unit is still useful, as a contribution margin is measured below gross profit.
Restaurants work out food cost from purchases and stock counts, so anything that leaves the kitchen without a sale ends up inside it. Staff meals are an employee benefit, yet they often inflate food costs. Spoilage belongs in food cost, but if it is never recorded, a rising food cost percentage cannot be traced to pricing, portioning, or waste. Prime cost (food plus labor) is a useful measure; it is not COGS.
Service and software-as-a-service (SaaS) businesses often hold no inventory, so they report cost of revenue or cost of services rather than COGS. The common mistake is filling that line inconsistently, with hosting in one quarter and sales engineers in the next, which makes gross margin impossible to compare over time.
Why COGS matters: Margin, pricing and tax
Gross margin: Gross profit divided by revenue. It shows how much of each sale is left to cover operating expenses and profit, and COGS is the only cost inside it.
Pricing floor: COGS per unit is the floor below which every sale loses money before any overhead is paid. A price that clears COGS by a thin margin can still lose money once delivery, commissions and returns are counted.
Tax: COGS reduces taxable profit, so the deduction is only as reliable as the inventory records behind it: the count, the costing method and the costs added to stock. What can be included and how it is reported are set by each country's tax rules, which your tax adviser can confirm for your business.
Inventory decisions: Margin by item shows which products earn their shelf space. Read alongside ABC analysis, it separates the high-value items that earn well from the ones that mainly tie up capital.
What lenders and investors look at: Gross margin is usually one of the first figures a lender or investor reads, because it shows whether the core of the business makes money before overheads. A margin that moves without explanation draws questions.
How to read your COGS
The simplest check is the COGS-to-revenue ratio: COGS divided by revenue. In the illustrative P&L above, 120,000 ÷ 200,000 = 60%. It is the mirror image of gross margin, and the two always add up to 100%.
There is no universal good ratio. A high-volume grocery retailer runs a high one on thin margins; a software company runs a low one. Compare your ratio against your own trend and against businesses that sell the same way.
Review it monthly, against the same month last year and against budget, as BDC recommends. A jump usually has a short list of causes: supplier prices, freight, product mix, shrinkage, write-downs or a change in how a cost is classified.
Look below the total. COGS by item and by sales channel shows where margin is actually made. A healthy overall ratio can hide a best-selling item that loses money through one channel.
The same figure drives inventory turnover, COGS divided by average inventory, which shows how quickly stock sells.
How to reduce COGS
Each lever below has a record in your inventory system that shows whether it is a problem.
Supplier terms and volume pricing: Renegotiate where spend concentrates. Purchase price history by item and vendor shows which prices have crept up.
Inbound freight: Consolidate shipments and combine orders from the same supplier. Landed cost per unit (product cost plus freight and duties) shows where freight is eating the margin.
Shrinkage and spoilage: Theft, damage, miscounts and expiry all end up in COGS. The stock adjustments log shows where and how often they happen.
Obsolete stock: Clearing slow movers while they still sell above cost avoids a larger write-down later. An aged stock report shows what has not moved.
Scrap and rework: For manufacturers, material lost in production raises the cost of every good unit. Production and scrap records show which processes waste most.
Product mix: Shifting sales towards higher-margin items lowers the COGS ratio without changing any single cost. A sales-by-item report with margin shows where to push.
Smaller, more frequent orders under just-in-time (JIT) inventory can reduce obsolescence write-downs, though freight per unit usually rises. Compare the two before changing order patterns.
How inventory software records COGS
In a perpetual system, COGS is posted at each sale, using the cost of the stock actually sold under the costing method you have set. Nothing waits for a period-end count.
That makes COGS visible per order, per item and per period as it happens. Stock counts then confirm the figure rather than produce it, and a gap between the two points to shrinkage, receiving errors or a costing problem. Regular cycle counting keeps that gap small.
Where Zoho Inventory fits
Zoho Inventory tracks stock by item and warehouse and records purchases and sales against each item. When it is connected to Zoho Books, COGS is posted as an invoice is raised for an inventory-tracked item; Zoho Books values it on a FIFO basis using actual purchase bill rates.
That gives you COGS and gross margin by item without a separate spreadsheet. Start a free trial of Zoho Inventory to see the cost of what you sell, item by item.
Frequently Asked Questions
Both. Materials, purchase costs, and freight-in rise and fall with the units you sell, so they are variable. Factory rent, supervisors' pay, and production equipment depreciation stay much the same each month, so they are fixed, yet they still belong in COGS. That is why COGS per unit usually falls as production volume rises.
Yes. When COGS exceeds revenue, the business makes a gross loss: it sold goods for less than they cost, before paying any overhead. Clearance sales below cost, heavy discounting, a large stock write-down, or costs rising faster than prices can all cause it. A one-off gross loss can be deliberate; a recurring one means prices or costs need fixing.
When returned goods go back into saleable stock, the sale is reversed, and so is its COGS: the cost moves from COGS back into inventory. If the goods are damaged and cannot be resold, their cost is written off instead, usually within COGS. The refund itself reduces revenue, and return shipping is an operating expense.
Generally not. Goods given away as samples, prizes, or promotional gifts are a marketing cost, so their cost moves from inventory to marketing expense. Stock used inside the business, such as parts for your own equipment or display units, goes to the expense it serves. In India, input tax credit on goods given away free is blocked and may need reversing.
Yes. A dropshipper never holds stock, but it pays a supplier for each item it sells, and that product cost is its COGS. Because the goods never sit in its inventory, the cost goes to COGS when the order is fulfilled, with no stock to count. Any delivery charge the supplier adds for shipping to the customer is a delivery cost.
Basic customs duty and other non-recoverable import charges are part of the goods' cost, so they reach COGS when the goods sell. In India, the integrated goods and services tax (IGST) paid on imports can usually be claimed as input tax credit, so it stays out of cost. If the credit cannot be claimed, the IGST is added to the cost too.
Goods sent on consignment still belong to the supplier, so they stay in the supplier's inventory until they are sold to the end customer, and only then does the supplier record COGS. The business holding the stock records neither inventory nor COGS for it, only its commission. Counting consigned stock as your own overstates inventory and understates COGS.
Goods in transit belong to whoever owns them under the shipping terms. If ownership passes when the supplier ships, they are your inventory while still on the road, even though they are not on your shelf. They become COGS only when you sell them. Recording the purchase but leaving them out of the count overstates COGS for the period.
A kit's COGS is the cost of every component in it, plus any assembly cost. If kits are assembled ahead of sale, the components move from inventory into kit stock at assembly and reach COGS when the kit sells. Tracking components separately keeps item margins accurate, because one component's price rise changes the cost of every kit that uses it.
Add purchases to beginning inventory, then subtract ending inventory: COGS = Beginning inventory + Purchases − Ending inventory. A manufacturer uses the cost of goods manufactured in place of purchases. The cost of goods sold formula guide works through an example and shows the journal entries.