Cost of goods sold (COGS): a guide for small businesses

Published Wednesday 27 May 2026

Table of contents

• What is COGS?
• What's included in COGS?
• COGS vs operating expenses
• How to calculate COGS
• Inventory valuation methods
• Examples of COGS
• Why COGS is important for small businesses
• COGS and different business models
• Tips for managing and reducing COGS
• Limitations of COGS
• Track your cost of goods sold 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 products you sell, and tracking it accurately is essential for setting profitable prices and claiming tax deductions.
• Use the right COGS formula for your business type: retailers track inventory changes over a period, while manufacturers add up raw materials, labour, and production costs.
• Your inventory valuation method, whether first in, first out (FIFO), last in, first out (LIFO), or weighted average cost, directly affects your COGS figure, your reported profit, and your tax obligations.
• Reduce COGS by negotiating with suppliers, minimising waste, investing in quality control, and using accounting software to track costs in real time.

What is COGS?

Cost of goods sold (COGS) is the total direct cost of producing or purchasing the goods your business sells during a specific period. It captures the expenses tied directly to making your products, not the overhead costs of running your business.

COGS typically includes these direct production costs:

• Direct materials: raw materials and components used in production
• Direct labour: wages for employees directly involved in making products
• Manufacturing overheads: factory costs like utilities and equipment maintenance
• Product-related costs: freight, storage, and sales commissions directly tied to selling products

Knowing your COGS helps you set prices that cover your costs, calculate your true gross profit, and make informed decisions about where to invest in your business.

What's included in COGS?

COGS covers only the direct costs of making or buying your products. The key test is whether a cost would disappear if you stopped producing or purchasing goods to sell.

Direct costs that belong in COGS:

• Direct materials: the raw materials that become part of your finished product
• Direct labour: wages for staff who physically make the product
• Manufacturing overheads: production-related costs like factory rent or utilities
• Packaging and freight: costs to prepare and ship products for sale

Indirect costs that do not belong in COGS:

• Marketing and advertising
• Salaries for sales staff and office workers
• General office expenses like rent and insurance
• Research and development

Learn more about operating expenses and how they differ from direct costs.

COGS vs operating expenses

COGS and operating expenses are both business costs, but they appear in different places on your income statement and serve different purposes. Understanding the distinction helps you calculate your margins accurately and identify where to cut costs.

COGS includes only costs directly tied to producing or purchasing the goods you sell. These are costs like raw materials, direct labour, and manufacturing overheads. On your income statement, you subtract COGS from revenue to get your gross profit.

Operating expenses are the indirect costs of running your business. They include rent, marketing, office salaries, insurance, and administrative costs. You subtract operating expenses from gross profit to arrive at your operating profit.

Here is a practical way to tell them apart: if the cost exists only because you produce or purchase products, it belongs in COGS. If the cost would remain even if you stopped selling products tomorrow, it is an operating expense.

Cost of sales vs cost of goods sold

You may see "cost of sales" and "cost of goods sold" used interchangeably, but there is a subtle difference. COGS refers specifically to the direct costs of producing or purchasing physical goods. Cost of sales is a broader term that can include the direct costs of delivering services as well.

For product-based businesses, the two terms mean the same thing. For service businesses or businesses that sell both products and services, cost of sales is the more accurate label because it captures labour and materials used to deliver services alongside any physical goods sold.

How to calculate COGS

To calculate COGS, use the formula that matches your business type. Retailers track inventory changes, while manufacturers add up production costs. Choose the method below that fits your business model.

Retail COGS formula

Retailers use this formula to calculate their cost of goods sold:

COGS = beginning inventory + purchases during the period − ending inventory

The formula components are:

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

This method tracks inventory value changes rather than individual sales. It automatically accounts for discarded, damaged, or unsold inventory, giving you a more accurate picture of your true costs.

Manufacturing COGS formula

Manufacturers have more complex supply chains, so it makes sense to add up all the costs on a product's journey to the customer. Some manufacturers choose not to include warehousing or freight.

COGS = raw materials + manufacturing costs + storage costs + freight

The formula components are:

• Raw materials: the direct materials used to produce goods
• Manufacturing costs: labour and production expenses
• Storage costs: warehousing and inventory holding expenses
• Freight: shipping costs for incoming materials or final delivery

In Xero, you can find your COGS in the profit and loss report under your income statement.

Inventory valuation methods

The method you use to value your inventory directly affects your COGS calculation, your reported profit, and your tax liability. There are three common inventory valuation methods, and each can produce a different COGS figure from the same set of transactions.

First in, first out (FIFO)

FIFO assumes you sell your oldest inventory first. When prices are rising, FIFO produces a lower COGS because the cheaper, older stock is counted as sold first. This results in higher reported profit but also a higher tax bill.

FIFO is the most commonly used method for small businesses. It closely matches how most physical goods actually move through a business, especially perishable products.

Last in, first out (LIFO)

LIFO assumes you sell your newest inventory first. When prices are rising, LIFO produces a higher COGS because the more expensive, recently purchased stock is counted as sold. This lowers your reported profit and can reduce your tax obligation.

LIFO is less common outside of the United States and may not be accepted under all accounting standards. In New Zealand, the accounting standards generally require FIFO or weighted average cost. Check with your accountant before using this method.

Weighted average cost

The weighted average cost method calculates a single average cost per unit based on the total cost of goods available for sale divided by the total number of units. Every unit is then valued at this average price.

This method smooths out price fluctuations over time. It is a practical choice when your inventory items are similar and interchangeable, such as bulk raw materials or uniform products.

Whichever method you choose, apply it consistently. Switching methods between periods makes it difficult to compare your financial results accurately. Xero helps you manage your inventory and maintain consistent records.

Examples of COGS

These examples show how COGS calculations work in practice for different business types.

Retail example: a clothing retailer starts the quarter with $10,000 in inventory, purchases $25,000 in new stock, and ends with $8,000 remaining.

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

The retailer spent $27,000 on the goods sold during the quarter. If revenue for the quarter was $45,000, the gross profit would be $18,000.

Manufacturing example: a furniture maker spends $7,000 on wood and materials, $3,000 on labour and factory costs, plus $1,200 on shipping finished products.

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

This represents the total direct cost to produce and deliver the furniture sold during that period.

Why COGS is important for small businesses

COGS is important because it determines your pricing strategy and profitability. Understanding your true direct costs ensures you price products competitively while maintaining healthy margins.

Small businesses often face these COGS-related challenges:

• Hidden costs: storage, shipping, transaction fees, and stock shrinkage add up
• Scaling costs: moving from home-based to dedicated facilities increases expenses
• Cost creep: rising supplier prices erode margins when not monitored

Tracking COGS helps you spot cost increases early so you can adjust prices before your profits drop.

Pricing

COGS sets your minimum price floor. You must charge more than your COGS to make a profit. When material costs rise by 10%, you know exactly how much to increase prices to protect your margins.

Profitability

Every dollar you save in COGS goes straight to your gross profit. Poor cost control can significantly reduce your markups. Even small increases in material or labour costs compound over time, directly cutting into profit.

Inventory management

Analysing COGS reveals how well you manage your inventory. A low stock turnover rate compared to your industry benchmark means you have too much stock sitting idle. Use this insight to adjust your stock levels and product range.

Taxes

COGS is tax-deductible as a business expense. When you track and document all COGS components accurately, you can claim more deductions and have the right records ready for audits. Find out how Inland Revenue handles COGS for your business.

Understanding your financial health

Understanding COGS helps you calculate accurate profit margins. Your gross profit margin shows what percentage of revenue remains after covering direct costs. Tracking this over time helps you build a more secure, predictable business.

Strategic decision-making

Tracking COGS closely supports better strategic decisions. With accurate cost data, you can evaluate whether to launch new products, invest in automation, or change distribution methods. Xero's analytics tools help you turn COGS data into useful information you can act on.

COGS and different business models

Different business types calculate COGS differently based on how they create value. The costs that count as COGS depend on whether you manufacture, resell, or provide services.

• Manufacturers include raw materials, production labour, and factory overheads. Some also include material handling and freight.
• Retailers calculate COGS using beginning and ending inventory values for a period, plus any purchases made during that time.
• Service businesses focus primarily on the direct labour costs to deliver services, plus any materials consumed during delivery.

For service businesses, COGS (sometimes called cost of sales) is typically smaller relative to revenue because the main cost is staff time rather than physical materials. If you run a service business, track the hours your team spends on client work and any supplies used to deliver each job.

Tips for managing and reducing COGS

Reducing your COGS directly increases your profit margins. These proven strategies help you lower costs without sacrificing quality.

Negotiate with suppliers

Regular supplier negotiations are one of the fastest ways to reduce your per-unit costs. Schedule quarterly price reviews to stay on top of market changes.

• Request volume discounts through long-term contracts or bulk orders
• Run competitive bidding by comparing quotes from multiple suppliers
• Ask for early payment discounts or extended payment terms

Invest in quality control

Catching defects early reduces rework, returns, and wasted materials. Set up quality checks at key stages of your production process. Even simple inspection routines can lower your defect rate and protect your margins.

Source cost-effective inputs

Review your materials regularly to identify more affordable alternatives that meet the same quality standards. Consider sourcing locally to cut freight costs, or explore different suppliers for components that make up a large share of your COGS.

Reduce waste

Track where materials are lost, damaged, or discarded during production or storage. Small improvements in waste reduction compound over time. Audit your processes quarterly and set targets for reducing scrap and spoilage.

Adopt lean practices

Lean practices focus on removing unnecessary steps from your production or purchasing process. Streamline your workflows to cut handling time, reduce excess inventory, and speed up your production cycle. Holding less stock also reduces storage and insurance costs.

Use technology to track costs

Manual cost tracking is slow and error-prone. Accounting software gives you real-time visibility into your COGS, highlights cost trends, and flags unexpected changes. Automated inventory tracking helps you maintain accurate records and make faster decisions.

Limitations of COGS

COGS is a valuable metric, but it does not tell you everything about your business's financial health. Understanding its limitations helps you use it alongside other measures for a complete picture.

COGS does not capture indirect costs like marketing, rent, or administrative salaries. A business with low COGS can still be unprofitable if its operating expenses are too high. Always review COGS together with your total expenses and net profit.

COGS can also be affected by your choice of inventory valuation method, which means two businesses with identical transactions can report different COGS figures. Seasonal fluctuations, supplier price changes, and currency movements can all distort COGS from one period to the next. Treat COGS as one part of a broader financial review, not a standalone indicator.

Track your cost of goods sold with Xero

Accurate COGS tracking helps you price your products with confidence, protect your margins, and make better business decisions. Xero's accounting software makes it straightforward to track your direct costs, manage inventory, and see your profit margins in real time. get one month free.

FAQs on cost of goods sold

Here are answers to frequently asked questions about COGS and how it applies to your business.

What is the difference between COGS and operating expenses?

COGS covers only the direct costs of making or buying what you sell, such as raw materials and direct labour, while operating expenses are indirect costs like rent, marketing, and administrative salaries. On your income statement, COGS is subtracted from revenue to get gross profit, and operating expenses are then subtracted to reach operating profit.

How do you calculate COGS?

Retailers calculate COGS by adding beginning inventory to purchases made during the period, then subtracting ending inventory. Manufacturers add up raw materials, direct labour, and production overheads instead.

What inventory valuation methods affect COGS?

The three main methods are FIFO (first in, first out), LIFO (last in, first out), and weighted average cost. Each method values your sold inventory differently, which changes your COGS figure, reported profit, and tax liability.

Can service businesses have COGS?

Yes, service businesses can have COGS if they incur direct costs to deliver their services, such as labour and materials consumed during delivery. Many accountants refer to this as "cost of sales" rather than COGS.

How often should you calculate COGS?

Calculate your COGS at least monthly to catch cost increases early and keep your pricing up to date. More frequent tracking gives you better visibility into your margins and helps you adjust before profits decline.