Cost of Goods Sold (COGS)

Cost of goods sold is the foundation of profitability analysis. It represents the direct costs of creating or acquiring the products you sell. For a manufacturer, COGS includes raw materials, factory labor, and production overhead. For a retailer, it is the wholesale cost of inventory. For a SaaS company, it includes server costs, third-party APIs, and direct support costs.

Accurately calculating COGS is essential because it determines gross profit and gross margin, the metrics that reveal whether your core business is viable before operating expenses. Understating COGS inflates apparent profitability and leads to poor pricing decisions. Common mistakes include excluding freight-in costs, overlooking shrinkage and spoilage, and failing to account for all direct labor.

COGS is a key input for tax calculations because it reduces taxable income. Businesses can use different accounting methods (FIFO, LIFO, weighted average) to value inventory and calculate COGS, each with different impacts on reported profits and taxes. Choosing the right method depends on industry norms, inventory turnover patterns, and tax planning strategies.