The cost of goods sold, or COGS, is a necessary part of calculating your company’s earnings over time. While the concept can seem a little confusing, it helps you better understand how your business makes money by factoring in how much it costs you to make each sale.
What Is COGS?
The cost of goods sold refers to the direct costs associated with each good you sell. Every product you sell requires some cost to you, either in terms of what you paid for it or the cost of the raw materials to create it. There are often labor costs needed to sell as well. COGS is categorized as an expense in your bookkeeping.
COGS is necessary for calculating your gross income, which, in turn, is needed to calculate your net income. This is because there is a cost to you for every sale you make.
What Expenses Count as COGS?
To calculate COGS, you should include any expenses directly related to the sale of each good or performance of a service. It is any cost of acquiring or manufacturing a good sold during a specified time period.
This can include the cost of raw materials to create your product or what you paid for your inventory. The labor costs for creating each good or sales commission would be COGS, too. Any packaging or freight payments would be COGS, although not shipping to your customers.
Importantly, you only calculate COGS for products you actually sold, not everything in your inventory.
What Expenses Don’t Count as COGS?
Expenses that aren’t considered COGS are often called overhead expenses. These are expenses you pay that are only indirectly connected to the sale of each individual good. Overhead includes costs like rent, marketing, or salaries for your salespeople.
When deciding whether an expense is COGS or not, a simple guideline is to ask whether you would pay the expense even if you did not make a sale that day. If you think you would pay the expense on a sales-less day, then it is probably not COGS.
Do Service-Based Business Calculate COGS?
While many pure service businesses don’t include COGS when calculating gross profit, like accountants or law firms, it might be relevant to your service-based company. In this situation, it might be best to think of the concept as “cost of revenue” as opposed to cost of goods sold.
Would you pay for an expense if you didn’t receive any revenue on a particular day? Commonly, your cost of revenue will include direct labor costs: the amount of money you would pay your staff to complete a task for a specific client, like junk removal, for example.
How to Calculate COGS
To calculate COGS, add up the direct costs for the manufacture or acquisition of each good or “unit” of service, like one hour of conducting a service. Then multiply this cost by the number of goods or units of service sold over a specified period. This is your COGS for that period.