Cost of goods sold (COGS): what it means for your business

Published Tuesday 19 May 2026

Table of contents

• What is cost of goods sold (COGS)?
• What is included in COGS?
• How to calculate COGS
• Examples of COGS
• Why COGS matters for small businesses
• How to reduce your COGS
• COGS accounting methods
• COGS vs. operating expenses
• Track your COGS with Xero
• FAQs on cost of goods sold

Key takeaways

• Cost of goods sold (COGS) is the total direct cost of producing or purchasing the goods your business sells. It includes materials, labour, and manufacturing overheads but excludes indirect costs like rent and marketing.
• Calculating COGS accurately helps you set profitable prices, manage inventory, and reduce your taxable income. The Canada Revenue Agency (CRA) allows you to deduct COGS as a business expense.
• A healthy COGS-to-revenue ratio for most small businesses falls between 50% and 65% of sales. Tracking this ratio over time helps you spot rising costs early and protect your margins.
• You can reduce COGS by negotiating better supplier terms, streamlining production, and optimizing your inventory levels to avoid waste and overstock.

What is cost of goods sold (COGS)?

Cost of goods sold (COGS) is the total direct cost of producing or buying the products your business sells during a specific period. It appears on your income statement and is subtracted from revenue to calculate gross profit.

COGS covers costs directly tied to production, such as raw materials, direct labour, and manufacturing overheads. It doesn't include indirect costs like office rent, marketing, or administrative salaries. Understanding the difference between direct and indirect costs is the first step toward accurate financial reporting.

What is included in COGS?

COGS includes every cost directly linked to making or acquiring your products. If a cost wouldn't exist without producing or purchasing goods, it likely belongs in COGS.

Costs included in COGS

The following direct costs typically form part of your COGS calculation:

• Raw materials and components used in production
• Direct labour: wages and benefits for employees who make or assemble products
• Manufacturing overheads: factory utilities, equipment depreciation, and maintenance
• Packaging materials
• Freight and shipping costs to receive inventory
• Storage costs for raw materials and finished goods
• Purchase price of goods bought for resale

Costs excluded from COGS

Indirect costs that keep your business running but aren't tied to production fall outside COGS. These are classified as operating expenses instead:

• Office rent and utilities
• Marketing and advertising
• Administrative salaries
• Sales team commissions
• Accounting and legal fees
• Software subscriptions unrelated to production

How to calculate COGS

The formula you use depends on whether your business buys goods for resale or manufactures them. Both methods rely on accurate inventory tracking to produce reliable numbers.

Retail formula

If you buy finished products and resell them, use this straightforward formula:

COGS = Beginning inventory + Purchases during the period - Ending inventory

Start with the value of inventory you had at the beginning of the period. Add any new inventory purchases. Then subtract the value of unsold inventory at the end of the period. The result is your cost of goods sold.

Manufacturing formula

If your business makes products, you'll need to account for additional production costs:

COGS = Raw materials + Manufacturing costs + Storage and freight costs

Raw materials include everything that goes into your finished product. Manufacturing costs cover direct labour and factory overheads like equipment maintenance and utilities. Storage and freight costs account for warehousing and transporting materials or finished goods.

Examples of COGS

Seeing COGS in action makes the formulas easier to apply. Here are two common scenarios for Canadian small businesses.

Retail example

Imagine you run a clothing shop. At the start of the quarter, your inventory is worth $10,000. During the quarter, you purchase $25,000 in new stock. At the end of the quarter, your remaining inventory is worth $8,000.

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

Your cost of goods sold for the quarter is $27,000. You'd subtract this from your total revenue to find your gross profit.

Manufacturing example

Suppose you make handmade candles. Over a month, you spend $7,000 on raw materials (wax, wicks, fragrance oils, and containers). Your direct labour and equipment costs total $3,000. Storage and freight costs add another $1,200.

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

Your COGS for the month is $11,200. Tracking each cost category separately helps you spot where spending is increasing.

Why COGS matters for small businesses

COGS directly affects your profitability, pricing decisions, and tax obligations. Monitoring it regularly gives you better control over your financial health.

Pricing

Knowing your exact cost per product helps you set prices that cover expenses and leave room for a healthy profit margin. If your COGS rises, you can adjust prices or find ways to reduce costs before margins shrink.

Profitability

COGS is the largest expense for most product-based businesses. According to the Business Development Bank of Canada (BDC), a healthy COGS-to-revenue ratio typically falls between 50% and 65% of sales. Tracking this ratio over time helps you benchmark against industry norms and spot problems early.

Subtracting COGS from revenue gives you your gross profit. A strong gross profit margin means more room to cover operating expenses and reinvest in growth. Learn how to measure profitability to put these numbers in context.

Inventory management

Calculating COGS requires you to track beginning and ending inventory values. This process naturally improves how you manage inventory, helping you avoid overstocking, reduce waste, and free up cash.

Taxes

The Canada Revenue Agency (CRA) allows you to deduct COGS when calculating your business income. Under CRA guidelines (IT-473R), you must use a consistent inventory valuation method from year to year. Canada accepts two methods for tax purposes: specific identification and average cost. The higher your COGS, the lower your taxable income, so accurate tracking can result in meaningful tax savings.

For full details on deducting inventory and COGS, see the CRA's inventory and cost of goods sold guide.

How to reduce your COGS

Lowering your COGS improves your gross profit without needing to raise prices. Here are three practical strategies to consider.

Negotiate with suppliers

Review your supplier contracts regularly and ask for volume discounts or better payment terms. Getting quotes from multiple suppliers helps you benchmark pricing. Even a small percentage reduction in material costs can add up significantly over a full year.

Streamline production

Look for ways to reduce waste, shorten production time, and consolidate freight costs. Batch shipping orders together rather than sending them individually can cut transportation expenses. Investing in more efficient equipment or processes may have upfront costs but can lower your per-unit production cost over time.

Optimize inventory levels

Carrying too much inventory ties up cash and increases storage costs. Carrying too little risks stockouts and lost sales. Use historical sales data to forecast demand and order accordingly. Regular inventory counts help you identify slow-moving stock before it becomes obsolete.

COGS accounting methods

The accounting method you choose affects how you value inventory and calculate COGS. Each method can produce different profit figures, even with identical transactions. Choose one that fits your business and stick with it for consistency.

First in, first out (FIFO)

FIFO assumes the oldest inventory items are sold first. During periods of rising prices, FIFO results in lower COGS and a higher gross profit margin because you're matching older, cheaper costs against current revenue. It's widely used in Canada and accepted under International Financial Reporting Standards (IFRS).

Last in, first out (LIFO)

LIFO assumes the newest inventory items are sold first. This method is not permitted in Canada under IFRS. If your business operates only in Canada, LIFO is not an option for your financial statements or tax filings.

Average cost

The average cost method (also called the weighted average method) divides the total cost of all inventory by the total number of units available for sale. This gives you a single average cost per unit. It's straightforward to calculate and smooths out price fluctuations over time. The CRA accepts this method for Canadian tax purposes.

Specific identification

Specific identification tracks the actual cost of each individual item. It works best for businesses that sell unique or high-value products, such as custom furniture or vehicles. The CRA also accepts this method. It gives you the most precise COGS figure but requires detailed record-keeping for every item.

COGS vs. operating expenses

COGS and operating expenses are both business costs, but they play different roles on your income statement. Understanding the difference helps you report your finances accurately and identify where your money goes.

COGS covers the direct costs of producing or purchasing the goods you sell. These costs exist only because you're making or buying products. Examples include raw materials, direct labour, and manufacturing overheads.

Operating expenses are the indirect costs of running your business. You'd pay these whether you sold one unit or one thousand. Examples include office rent, marketing spend, insurance, and administrative salaries.

On your income statement, COGS is subtracted from revenue to give you gross profit. Operating expenses are then subtracted from gross profit to give you operating profit. Keeping these categories separate makes it easier to see whether rising costs come from production or from running the business. Your profit and loss statement breaks these out clearly.

Track your COGS with Xero

Accurate COGS tracking helps you price confidently, protect your margins, and file your taxes correctly. With cloud accounting software, you can automate inventory tracking, pull real-time financial reports, and stay on top of your numbers without spreadsheets.

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FAQs on cost of goods sold

Here are some frequently asked questions about cost of goods sold.

What is the difference between COGS and cost of sales?

COGS and cost of sales are often used interchangeably for product-based businesses. However, cost of sales is a broader term that can also include direct costs in service businesses, such as the labour cost of delivering a service. If your business sells physical goods, the two terms mean the same thing.

How often should you calculate COGS?

Most small businesses calculate COGS monthly or quarterly to stay on top of profitability trends. At minimum, you'll need to calculate it annually for your tax return. More frequent calculations help you spot cost increases early and make timely pricing adjustments.

Can you estimate COGS?

You can estimate COGS using the gross profit method if you don't have exact inventory figures. This approach applies your historical gross profit margin to current sales to estimate the cost of goods sold. It's useful for interim reporting, but you should use actual inventory counts for year-end financial statements and tax filings.

Do service businesses have COGS?

Pure service businesses typically don't have COGS because they don't sell physical products. However, if your service involves materials or supplies consumed during delivery, those direct costs may qualify. For example, a landscaping company's soil and plant costs could count. The CRA looks at whether the cost is directly tied to generating revenue.

Is COGS a deductible expense in Canada?

Yes. The CRA allows you to deduct COGS when calculating your net business income. You must maintain accurate records of your inventory and use a consistent valuation method. Proper documentation on your balance sheet and income statement supports your deduction if the CRA reviews your filing.