COGS explained: what it is and how to calculate it

Published Wednesday 27 May 2026

Table of contents

• What is COGS?
• COGS vs. cost of sales
• How to calculate COGS
• Examples of COGS
• COGS and different business models
• Why COGS is important for small businesses
• COGS accounting methods
• Tips for managing and reducing COGS
• Limitations of COGS
• Track COGS and stay on top of your margins with Xero
• FAQs on COGS

Key takeaways

• Cost of goods sold (COGS) is the total direct cost to produce or purchase the goods you sell, and you can calculate it using the formula: Beginning Inventory + Purchases − Ending Inventory = COGS.
• Tracking COGS regularly helps you set prices above your direct production costs, spot rising expenses early, and protect your profit margins before they erode.
• Choosing an inventory valuation method such as FIFO or average cost and applying it consistently is essential, as your choice directly affects reported COGS, gross profit, and tax obligations.
• You can reduce COGS by negotiating volume discounts with suppliers, streamlining production processes, keeping inventory levels lean, and consolidating freight to cut shipping costs.

What is COGS?

Cost of goods sold (COGS) is the direct cost to produce or purchase the goods you sell. It includes raw materials, manufacturing labour, and other expenses directly tied to creating your products. Knowing your COGS helps you set profitable prices and understand your true margins.

COGS sits on your income statement above the gross profit line. The relationship is straightforward: Revenue − COGS = Gross Profit. This figure tells you how much money is left after covering direct production costs, before accounting for overheads like rent and marketing.

COGS typically includes the following direct costs.

• Direct materials: Raw materials and components used in production.
• Direct labour: Wages for workers who make your products.
• Manufacturing overheads: Factory costs like equipment and utilities.
• Freight and storage: Shipping and warehousing costs directly tied to production.
• Transaction fees: Payment processing costs for some business models.

Manufacturers have more complex supply chains. It makes sense for them to add up all the costs on their product's journey to the customer. Be aware that some choose not to count warehousing or freight.

COGS excludes indirect business costs such as the following.

• Rent and utilities: Office space costs unrelated to production.
• Marketing and advertising: Promotional expenses.
• General administrative costs: Back-office operations.
• Non-production salaries: Wages for staff not directly making products.

Use accounting software to track your cost of goods sold, manage your expenses, and control your inventory. Small businesses with an aggregated turnover under $50 million can use the instant asset write-off to immediately deduct the cost of eligible assets, including technology, up to the applicable threshold.

COGS vs. cost of sales

You'll often see "cost of goods sold" and "cost of sales" used interchangeably, but there's a subtle difference worth understanding.

COGS refers specifically to the direct costs of producing or purchasing physical goods. It applies to businesses that sell tangible products, such as retailers, manufacturers, and wholesalers. Cost of sales is a broader term that covers the direct costs of generating revenue for any business type, including service providers.

For a consulting firm, cost of sales might include consultant wages and project-specific software licences. For a restaurant, it could include ingredients, kitchen staff wages, and cooking supplies. These aren't traditional "goods," but they're direct costs of delivering the service.

In practice, most Australian small businesses that sell physical products can treat the two terms as equivalent. If you run a service-based business, "cost of sales" is the more accurate label for your direct costs. The calculation method and purpose remain the same either way: tracking how much it costs to deliver what you sell.

How to calculate COGS

The basic COGS formula for retailers and product-based businesses is straightforward to apply once you have accurate inventory records.

Beginning Inventory + Purchases − Ending Inventory = COGS

Each component represents the following.

• Beginning inventory: The value of stock at the start of the period.
• Purchases: The cost of new inventory acquired during the period.
• Ending inventory: The value of unsold stock at the end of the period.

This formula works because it captures all inventory that left your business, whether sold, damaged, or discarded. You don't need to track individual sales; the difference between starting and ending inventory tells you what moved.

Manufacturers typically use a different formula that reflects their production process.

Raw Materials + Manufacturing Costs + Storage + Freight = COGS

Each component represents the following.

• Raw materials: Direct materials used in production.
• Manufacturing costs: Labour, equipment, and factory expenses.
• Storage costs: Warehousing expenses for materials and finished goods.
• Freight: Shipping costs for incoming materials or outgoing products.

Some manufacturers exclude storage or freight. Choose a method and apply it consistently.

If you use Xero accounting software, you can find cost of goods sold in the profit and loss or income sections of your financial statements.

Examples of COGS

Seeing how the COGS formula works with real numbers makes the calculation easier to understand and apply to your own business.

Retail example

A retail business starts the quarter with $10,000 of inventory, purchases $25,000 during the quarter, and ends with $8,000 remaining.

COGS = $10,000 + $25,000 − $8,000 = $27,000

This means $27,000 worth of inventory was sold or used during the quarter.

Manufacturing example

A manufacturer spends $7,000 on materials, $3,000 on labour and energy, and $1,200 on shipping.

COGS = $7,000 + $3,000 + $1,200 = $11,200

This represents the total direct cost to produce and deliver the goods.

COGS and different business models

Different business models calculate COGS differently, so it's important to identify which costs count as "direct" for your type of operation.

• Manufacturers: Include production costs like materials, labour, and factory overheads.
• Retailers: Track inventory changes between the start and end of each period.
• Service businesses: Count labour and materials used to deliver services.

Why COGS is important for small businesses

COGS reveals your true production costs so you can set profitable prices and avoid undercharging. Without accurate COGS tracking, small businesses often miss hidden costs that erode margins. COGS data also informs strategic decisions about new product lines, automation investments, and distribution methods.

Common challenges small businesses face with COGS include the following.

• Scaling costs: Dedicated facilities cost more than home-based operations.
• Overlooked expenses: Warehousing, handling, and freight add up quickly.
• Seasonal fluctuations: Material costs change throughout the year.

Understanding COGS helps you make better decisions in four key areas.

Pricing

COGS sets your pricing floor. You must price above your COGS to generate profit. If your COGS is $15 per unit, pricing at $20 gives you $5 gross profit to cover other expenses.

Labour costs, a key COGS component, continue to rise for Australian small businesses, with wages growing +2.0% year-on-year in the December quarter of 2025 according to Xero Small Business Insights data from over 520,000 businesses. Track COGS regularly. When costs rise, you'll know it's time to adjust prices or find efficiencies.

Profitability

Lower COGS means higher profits when selling prices stay the same. A 10% reduction in COGS flows directly to your gross margin. Typical gross profit margins vary significantly by business type; retail businesses generally achieve margins between 20% and 40%, while service businesses often reach 50% or higher. Knowing where your industry sits helps you benchmark whether your COGS is competitive.

The gross profit formula is: Revenue − COGS = Gross Profit. For example, if your revenue is $100,000 and your COGS is $60,000, your gross profit is $40,000.

COGS affects gross profit, while net profit also depends on operating expenses like wages, rent, and depreciation. Understanding your COGS is essential for calculating accurate profit margins and building long-term financial security.

Inventory management

Tracking COGS helps you spot inventory problems. You can identify slow-moving items, optimise stock levels, and adjust your product mix based on which items deliver the best margins.

Inaccurate inventory tracking can be costly. Unaccounted stock losses, damaged goods, and shrinkage can significantly erode your gross profit margin over time. Review your product mix regularly to catch these issues early.

Taxes

COGS is a tax-deductible expense. Accurate tracking helps you maximise deductions and provides documentation if you're audited. The ATO notes that if your trading stock's value has changed by no more than $5,000, you may not have to conduct a formal stocktake. Incorrect valuations can trigger additional tax assessments.

Check the Australian Taxation Office website for specific guidance on income and deductions for business.

COGS accounting methods

Your inventory valuation method directly affects reported profits and tax obligations. Different methods assign different costs to sold items, which changes your COGS figure. Australian businesses must follow AASB 102 (Inventories) when valuing stock.

When you sell inventory, its value moves from your balance sheet (as an asset) to your income statement (as a COGS expense).

FIFO (first in, first out) method

FIFO assumes you sell your oldest inventory first. During inflation, FIFO shows lower COGS because you're matching old, cheaper costs against current revenue. This results in higher reported profits and higher taxes.

LIFO (last in, first out) method

LIFO assumes you sell your newest inventory first. During inflation, LIFO shows higher COGS because you're matching recent, higher costs against current revenue. This results in lower reported profits and lower taxes.

Note that LIFO is not permitted under Australian accounting standards (AASB 102). Most Australian businesses use FIFO or average cost methods.

Average cost method

Average cost calculates a weighted average of all inventory costs. This method smooths out price fluctuations and provides consistent COGS figures between FIFO and LIFO extremes. It's a popular choice for businesses that sell large volumes of similar items.

Special identification method

Special identification tracks the actual cost of each individual item in your inventory. It's used when you sell high-value, unique, or easily distinguishable products such as cars, jewellery, artwork, or real estate. This method gives you the most accurate COGS figure because it matches the exact purchase cost to each sale. However, it's only practical for businesses with low inventory volumes and items that can be individually tracked.

Tips for managing and reducing COGS

Once you understand your COGS, you can take practical steps to bring it down and improve your margins.

1. Negotiate with suppliers

Build stronger supplier relationships to reduce material costs.

• Schedule regular price reviews: Meet quarterly to discuss rates and identify savings.
• Negotiate volume discounts: Commit to bulk purchases for consistent cost reductions.
• Research alternative suppliers: Maintain competitive options to strengthen your negotiating position.

2. Streamline production processes

Review your production workflow to identify waste and inefficiencies. Map each step and look for bottlenecks or redundant processes.

Automation can reduce labour costs and improve consistency. Calculate the return on investment before committing to major equipment purchases. Check the ATO website for current incentives that may apply to energy-efficient equipment.

3. Optimise inventory levels

Use sales data to forecast demand and avoid overstocking. Holding excess inventory ties up cash and increases storage costs.

Review your product mix regularly. Items that haven't sold in 90 days may be worth discontinuing or discounting to free up capital.

4. Reduce freight costs

Reduce shipping costs without sacrificing delivery speed by exploring these approaches.

• Compare shipping methods: Balance cost against delivery time for each product type.
• Consolidate shipments: Combine orders to access bulk shipping rates.
• Negotiate carrier contracts: Secure volume discounts based on your shipping frequency.
• Consider third-party logistics: Outsource fulfilment to specialists who can negotiate better rates.

Limitations of COGS

While COGS is a valuable metric, it has some important limitations to keep in mind when making business decisions.

COGS figures can vary depending on the inventory valuation method you choose. Two businesses with identical inventory and sales can report different COGS simply because one uses FIFO and the other uses average cost. This makes it tricky to compare your figures directly with competitors unless you know their method.

COGS also excludes indirect costs like rent, marketing, and administrative expenses. A low COGS doesn't automatically mean high overall profitability if your overheads are significant. You'll need to look at net profit alongside COGS for the full picture.

Finally, COGS is less meaningful for pure-service businesses that don't carry inventory. If your business is entirely service-based, cost of sales is a more useful metric for tracking direct costs.

Track COGS and stay on top of your margins with Xero

Calculating COGS manually takes time, and mistakes can lead to inaccurate pricing and missed tax deductions. Cloud-based accounting software simplifies the process by pulling in your inventory data, tracking expenses automatically, and generating profit and loss reports whenever you need them.

Xero gives you real-time visibility into your cost of goods sold, gross profit margins, and inventory levels, so you can make confident pricing and purchasing decisions. With bank feeds that reconcile daily and reports you can check from anywhere, you'll spend less time on the books and more time growing your business. Get one month free.

FAQs on COGS

Here are answers to frequently asked questions about cost of goods sold.

What's the difference between COGS and operating expenses?

COGS includes only direct costs to produce goods, like materials and manufacturing labour. Operating expenses cover indirect costs like rent, marketing, and administrative salaries that keep your business running but aren't tied to specific products. Both appear on your income statement, but COGS is subtracted from revenue first to calculate gross profit.

Can service businesses calculate COGS?

Yes. Service businesses calculate COGS (often called cost of sales) by tracking direct labour and materials used to deliver services. For example, a cleaning business would include cleaning supplies and cleaner wages. However, if your business has no direct costs tied to delivering services, you may not have a COGS figure at all.

How often should I calculate COGS?

Calculate COGS at least quarterly for tax reporting. Many businesses track it monthly to monitor pricing and profitability more closely. Real-time tracking through accounting software provides the most timely insights and removes the risk of manual errors.

Does COGS include shipping to customers?

It depends on your business model. Manufacturers often include outbound freight as COGS. Retailers typically count shipping as an operating expense. Choose one approach and apply it consistently so your financial reports stay comparable across periods.

Is COGS an expense?

Yes, COGS is classified as an expense on your income statement. It's deducted from revenue to calculate gross profit. However, it's reported separately from operating expenses because it represents the direct costs of producing or purchasing goods, not the indirect costs of running your business.

What is cost of sales vs. cost of goods sold?

Cost of goods sold refers specifically to the direct costs of producing or purchasing physical products. Cost of sales is a broader term that includes the direct costs of generating revenue for any business type, including services. For product-based businesses, the two terms are effectively interchangeable. Service businesses should use "cost of sales" for accuracy.