COGS: What cost of goods sold means for your business

Published Monday 2 February 2026

Table of contents

• What is COGS?
• How to calculate COGS
• Examples of COGS
• COGS and different business models
• Why COGS is important for small businesses
• Tips for managing and reducing COGS
• COGS accounting methods
• Track your COGS with Xero
• FAQs on COGS

Key takeaways

• Calculate COGS using the appropriate formula for your business type: retailers should use beginning inventory plus purchases minus ending inventory, while manufacturers should add up raw materials, manufacturing costs, storage costs, and freight expenses.
• Monitor COGS regularly to set profitable pricing by ensuring your prices stay above your true costs, and use this data to identify when price adjustments are needed due to cost changes.
• Reduce COGS through strategic supplier negotiations, production process optimization, and inventory management by securing volume discounts, eliminating workflow inefficiencies, and discontinuing slow-moving products.
• Track COGS accurately for tax purposes since it's a deductible business expense that directly impacts your gross profit and helps you make informed decisions about pricing, inventory levels, and business investments.

What is COGS?

Cost of goods sold (COGS) is the direct cost to produce or purchase the goods you sell. COGS represents the actual money you spend on materials, labour, and manufacturing to create your products.

COGS typically includes:

• Direct materials: Raw materials and components used in production
• Direct labour: Wages for workers who directly make your products
• Manufacturing overheads: Factory costs like utilities and equipment

COGS may also include:

• Freight costs: Shipping expenses for materials or finished goods
• Storage costs: Warehouse expenses directly related to inventory
• Transaction fees: Payment processing costs for product sales

COGS excludes indirect expenses like rent, marketing, administrative overhead, and most salaries.

Tracking COGS requires accounting software for running your business and managing your expenses and inventory.

How to calculate COGS

COGS calculation depends on your business type. Retailers use inventory-based formulas, while manufacturers add up production costs. Both methods give you the true cost of goods sold during a specific period.

Retail COGS formula

Cost of goods sold formula used by retailers for inventory accounting.

Here's a breakdown of the components of the retail COGS formula:

• Beginning inventory: The value of inventory at the start of the period
• Purchases: Cost of inventory acquired during the period
• Ending inventory: The value of inventory remaining at the end of the period

This formula focuses on inventory value, not sales volume. It tracks what inventory you started with, what you bought, and what remained unsold. This approach accounts for discarded or damaged inventory that never generated revenue.

Manufacturing COGS formula

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.

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.

Here's a breakdown of the components of the manufacturing COGS formula:

• Raw materials: The direct materials used to produce goods
• Manufacturing costs: Costs of production
• Storage costs: Expenses from inventory storage
• Freight: Any shipping costs for incoming materials or final delivery

If you use accounting software like Xero, you can see COGS on your profit and loss (P&L) statement.

Examples of COGS

A retail business holds $10,000 of inventory at the beginning of the quarter, and it buys $25,000 during the quarter. At the end, it owns $8,000.

The equation is:

$10,000 + $25,000 − $8,000 = $27,000

A manufacturing business buys $7,000 worth of materials and spends $3,000 of energy and labour, turning it into goods, plus $1,200 on shipping.

The equation is:

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

COGS and different business models

COGS is calculated differently depending on your business model. For example:

• Manufacturers tend to include certain indirect costs, such as material handling costs
• Retailers often calculate COGS using starting and ending inventory for a period
• Service businesses are more likely to include labour

Why COGS is important for small businesses

COGS is essential for profitable pricing. You need to know your true costs to set competitive prices that generate profit.

Hidden costs often surprise new business owners. Materials and labour are easy to track, but other expenses can catch you off guard. Home-based businesses may see COGS increase when they move to dedicated facilities.

Regular COGS monitoring protects your profit margins by identifying cost pressures before they impact your bottom line.

COGS drives better business decisions in four critical areas:

Pricing

COGS sets your minimum pricing threshold. You must price above your COGS to generate profit. When costs change, COGS data shows you exactly when and how much to adjust your prices.

Profitability

Lower COGS directly increasesyour gross profit. Reduce costs by even small amounts while keeping prices steady, and you'll see significant profit improvements.

COGS is one part of your total operating expenses. Your operating income also includes wages, depreciation, and other business costs.

Inventory management

COGS analysis reveals inventory inefficiencies. It identifies slow-moving products and helps optimize stock levels. You can balance customer demand while reducing the money tied up in unsold inventory.

Taxes

COGS is a deductible business expense, and for income tax purposes, there are two acceptable methods for valuing inventory. Tracking and documenting all the components of COGS according to these rules makes it easier to maximize deductions and provide the necessary audit documents.

Check with your local tax authority for how they handle COGS.

Understanding your financial health

Understanding COGS is key to calculating your profit margins to build a secure business.

Strategic decision-making

With a close eye on COGS accounting, you can make better decisions. COGS gives you the context for strategic financial analysis to inform decisions like investing in new product lines, automation, or new distribution methods.

Tips for managing and reducing COGS

Negotiate with suppliers

Supplier negotiation strategies:

• Schedule regular price discussions to secure better rates
• Consider long-term contracts for volume discounts
• Research alternative suppliers for competitive pricing comparisons

Streamline production processes

Production optimization steps:

• Analyze your workflow to identify waste and inefficiencies
• Evaluate automation opportunities to reduce labour costs
• Calculate ROI impact before making equipment investments

Optimize inventory levels

Inventory optimization tactics:

• Use sales data to forecast demand accurately
• Review product performance regularly to identify slow movers
• Discontinue underperforming items to free up capital

Reduce freight costs

Explore alternative shipping methods that balance cost and delivery time. For example, by consolidating shipments you can access bulk shipping rates. Try negotiating with carriers for volume discounts or think about a third-party logistics provider to optimize your shipping strategy.

COGS accounting methods

The method you use to value inventory directly affects the COGS calculation. As you sell inventory, its value transfers from the balance sheet to the income statement as part of COGS. The inventory valuation methods you choose determine which costs are assigned to sold items and which remain in inventory.

FIFO (first in, first out) method

FIFO assumes that the oldest inventory items are sold first. This method often results in COGS that closely matches the physical flow of goods. When prices are increasing, FIFO typically leads to lower COGS and higher reported profits.

LIFO (last in, first out) method

LIFO assumes the most recently acquired inventory is sold first. This can lead to higher COGS and lower profits during periods of inflation. Note that LIFO is not permitted under International Financial Reporting Standards (IFRS) cost-accounting principles and is disallowed in many countries outside the United States.

Average cost method

This method uses the weighted average inventory costs of individual items to value both COGS and ending inventory. It smooths out price fluctuations and is a middle ground between FIFO and LIFO.

Specific identification method

This method tracks the actual cost of each inventory item. It's typically used for high-value items. While accurate, it can be impractical for businesses with large quantities of similar items.

Track your COGS with Xero

Understanding your COGS is key to making smart business decisions, but calculating and managing it can be complex. Using accounting software simplifies the process, giving you real-time reports and clear insights into your costs.

When you track your COGS accurately, you protect your profit margins and build a healthier business. Try Xero for free and get started today.

FAQs on COGS

Here are answers to common questions about cost of goods sold (COGS).

What's the difference between COGS and operating expenses?

COGS covers the direct costs of creating products, while operating expenses are the indirect costs of running the business, such as rent, marketing, and staff and so on.

What is the difference between cost of goods sold and cost of sales?

These are often used interchangeably. However, COGS focuses on the direct costs of creating or purchasing products that are sold. Cost of Sales (COS) sometimes includes those costs plus additional business expenses linked to revenue generation, like transaction fees, sale commissions, or acquisition costs in some digital businesses.

How often should I calculate COGS?

Most businesses calculate COGS monthly, quarterly, or annually. According to Canadian government accounting standards, a complete physical inventory count must be taken at least annually if a periodic system is used. High-turnover businesses may need more frequent calculations for accurate profitability tracking.

Can I estimate my COGS?

Yes, estimates work for new businesses with limited resources. As you grow, accurate COGS tracking becomes essential for profitability and tax compliance. Accounting software simplifies this process significantly.

My business is service-based. Do I still have COGS?

Yes, service businesses have COGS too. These direct costs can include labour, software, and materials. For certain professional practices, it's important to note that for tax years starting after March 21, 2017, they can no longer elect to exclude work-in-progress (WIP) from their inventory calculations.