COGS explained: what it is and how to calculate it

Published Monday 29 June 2026

Table of contents

• What is COGS?
• What's included in COGS (and what's not)
• Why COGS is important for small businesses
• How to calculate COGS
• COGS and inventory valuation methods
• Examples of COGS
• COGS and different business models
• Cost of sales vs cost of goods sold
• How to reduce your COGS
• Track your COGS with Xero
• FAQs on cost of goods sold

Key takeaways

• Cost of goods sold (COGS) covers the direct costs of producing or purchasing the products you sell, including materials, labour, and manufacturing overheads.
• Tracking COGS accurately helps you set profitable prices, manage stock levels, and identify where to cut costs in your supply chain.
• UK businesses typically use FIFO or the average cost method to value inventory, as LIFO isn't permitted for UK tax purposes.
• From April 2026, self-employed businesses earning over £50,000 must keep digital COGS records under Making Tax Digital for Income Tax.

What is COGS?

Cost of goods sold (COGS) is the total direct cost of producing or purchasing the products your business sells. It's one of the most important figures on your profit and loss statement because it directly affects your gross profit.

COGS includes costs that are directly tied to production or procurement. These typically fall into three categories:

• Direct materials: raw materials, components, or finished goods you buy to resell
• Direct labour: wages for employees who work directly on producing your products
• Manufacturing overheads: factory rent, equipment depreciation, and utilities used in production

COGS doesn't include indirect costs like office rent, marketing spend, or administrative salaries. Your business records these as operating expenses instead. HMRC guidance on costs directly attributable to production can help you determine which expenses qualify.

What's included in COGS (and what's not)

Knowing exactly which costs fall under COGS helps you report accurate figures and avoid overstating your expenses. Here's a clear breakdown.

Costs typically included in COGS:

• Purchase price of raw materials or finished goods for resale
• Freight and shipping costs for inbound goods
• Direct labour costs tied to production
• Manufacturing overheads such as factory utilities and equipment depreciation
• Transaction fees on product sales
• Sales commissions directly tied to selling goods

Costs not included in COGS:

• Office rent and utilities unrelated to production
• Marketing and advertising spend
• Administrative salaries
• Distribution costs after production is complete
• Research and development expenses

The distinction matters because COGS and operating expenses serve different purposes on your financial statements. You subtract COGS from revenue to calculate gross profit. You then subtract operating expenses from gross profit to reach net profit. Misclassifying costs between the two can distort your profit margins and lead to poor decisions.

Why COGS is important for small businesses

Your COGS shows where your money goes and how much you actually earn from each sale. It affects everything from pricing to tax compliance.

Pricing

Your COGS is the baseline for setting prices. If you don't know what it costs to produce or buy each product, you can't set prices that cover your expenses and leave room for profit. Accurate COGS figures help you build pricing strategies that keep your business competitive and profitable.

Profitability

COGS directly determines your gross profit margin. A rising COGS without a matching increase in revenue means your profitability is shrinking. Monitoring this figure regularly helps you spot trends early and take steps to increase profits before margins erode.

Inventory management

COGS and inventory levels are closely linked. Tracking COGS accurately shows you which products cost the most to stock. It also reveals which deliver the best returns. This helps you make smarter purchasing decisions and avoid tying up cash in slow-moving stock. Good inventory accounting practices depend on reliable COGS data.

Taxes

COGS is a deductible business expense that reduces your taxable income. Reporting it accurately ensures you claim the correct amount and stay compliant with HMRC rules on trading expenses.

From April 2026, self-employed businesses earning over £50,000 must use Making Tax Digital for Income Tax. This requires digital record-keeping and quarterly updates, which includes tracking COGS.

Strategic decision-making

COGS data helps you make informed choices about suppliers, product lines, and production methods. If one product has a much higher COGS than another, investigate why. You can then renegotiate supplier terms, adjust your process, or discontinue the product. Access to accurate financial reports makes these decisions easier.

How to calculate COGS

The formula you use depends on whether your business buys finished goods for resale or manufactures products from raw materials.

Retail COGS formula

If you buy and resell products, use this formula:

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

Start with the value of stock you had at the beginning of the period. Add the cost of any new stock you purchased. Then subtract the value of stock remaining at the end of the period. The result is your COGS for that period.

Manufacturing COGS formula

If you make your own products, the calculation includes more cost categories:

COGS = direct materials + direct labour + manufacturing overheads

Direct materials cover the raw inputs used in production. Direct labour includes wages for workers who build or assemble the product. Manufacturing overheads account for factory costs like equipment depreciation and utilities used during production.

COGS and inventory valuation methods

The method you use to value your inventory affects your COGS figure. Different valuation methods assign costs to sold goods in different ways, which can change your reported profit.

First in, first out (FIFO)

FIFO assumes the oldest stock is sold first. In times of rising prices, FIFO results in a lower COGS because the cheaper, earlier-purchased items are matched against revenue first. This is the most commonly used method for UK businesses.

Average cost method

The average cost method calculates a weighted average cost per unit across all inventory. Each time you sell a unit, the cost assigned is the current average. This smooths out price fluctuations and is straightforward to apply.

Specific identification

Specific identification tracks the actual cost of each individual item. It works well for businesses that sell unique or high-value products, such as art dealers or custom furniture makers. It's less practical for businesses with large volumes of identical items.

Note that LIFO (last in, first out) is not permitted for UK tax purposes. HMRC's guidance on stock valuation confirms that UK businesses must use an accepted method such as FIFO or average cost.

Examples of COGS

Seeing COGS in action makes the concept easier to apply to your own business. Here are two common examples.

A clothing shop starts the quarter with £10,000 worth of stock. During the quarter, the owner purchases £25,000 in new inventory. At the end of the quarter, £8,000 worth of stock remains unsold.

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

Now consider a candle maker who spends £7,000 on wax, wicks, and fragrance oils during the month. Direct labour costs come to £3,000, and manufacturing overheads total £1,200.

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

COGS and different business models

How COGS applies to your business depends on what you sell and how you deliver it.

• Manufacturers. COGS includes raw materials, direct labour, and production overheads. This is the most complex calculation because multiple cost categories feed into each finished product.
• Retailers. COGS covers the purchase price of goods bought for resale, plus any freight or shipping costs. It's more straightforward to calculate because there's no production stage.
• Service businesses. Pure service businesses often don't have a traditional COGS because they don't sell physical products. Some service providers track "cost of sales" to capture direct delivery costs such as contractor fees or project-specific materials.

Cost of sales vs cost of goods sold

These two terms are often used interchangeably, but there's a useful distinction.

COGS refers specifically to the direct production costs for physical goods. Cost of sales is a broader term that can also include the direct costs of delivering services, such as consultant fees or software licensing costs tied to a specific project.

In UK accounting practice, "cost of sales" is the standard term in Companies Act filings. You'll typically see it as the line item on the profit and loss account. For day-to-day management, both terms are useful depending on whether you're discussing goods, services, or both.

How to reduce your COGS

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

• Negotiate with suppliers for better rates, especially if you can commit to larger or longer-term orders.
• Buy raw materials or stock in bulk to take advantage of volume discounts.
• Improve production efficiency by reviewing your processes for bottlenecks or wasted time.
• Reduce waste by tracking materials usage and identifying where scrap or spoilage occurs.
• Review your inventory management to avoid overstocking items that tie up cash or expire.
• Consider alternative materials or suppliers that offer comparable quality at a lower cost.

Even small reductions in COGS can have a meaningful impact on your bottom line over time. Use your financial analytics to track progress and measure the effect of any changes you make.

Track your COGS with Xero

Accurate COGS tracking doesn't have to be time-consuming. Xero's cloud accounting software helps you monitor costs, manage inventory, and generate profit and loss reports in real time. With features like automatic bank reconciliation and customisable financial reports, you can see exactly how your direct costs affect profitability.

Xero also helps you stay compliant as Making Tax Digital requirements expand. Your records are digital from the start, so quarterly reporting is simpler. Try Xero for your business and get one month free.

FAQs on cost of goods sold

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

What's the difference between COGS and operating expenses?

COGS covers direct production or purchasing costs for the goods you sell. Operating expenses include indirect costs like rent, marketing, and administrative salaries that aren't tied to a specific product.

Which inventory valuation method should I use?

Most UK small businesses use FIFO or the average cost method. FIFO works well when stock prices change frequently, while average cost is simpler to manage. LIFO isn't allowed for UK tax purposes.

How often should I calculate COGS?

Calculate COGS at least monthly to keep your financial reports accurate. If you sell high volumes of stock, weekly tracking gives you more timely insights into profitability.

Is COGS an expense?

Yes, COGS is recorded as an expense on your profit and loss statement. You deduct it from revenue to calculate gross profit. That makes it one of the most important figures for your business's financial health.

Are salaries included in COGS?

Only salaries for employees directly involved in producing goods count as COGS. Wages for production line workers or assembly staff qualify. Salaries for office administrators, managers, or sales staff count as operating expenses.

How does COGS affect gross profit?

Gross profit equals revenue minus COGS. A higher COGS reduces your gross profit, even if revenue stays the same. Keeping COGS in check is one of the most direct ways to protect your margins.